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CHAPTER 5

BINOMIAL ASSET PRICING

MODEL
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5.1 Binomial Model -Introduction
In the binomial asset pricing model, we model the stock
prices in discrete time, assuming that each step, the stock
price will change to one of two possible values.
Of course stock price moments are much more
complicated than indicated by the binomial asset pricing
model.
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We consider this simple model for these reasons:
•Within the model the concept of arbitrage pricing and its
relation to risk natural pricing is clearly eliminated.

•The model is used to practice because with a sufficient

number of steps it provides a good computationally
tractable approximation to the continuous time model
4 5.2 One Step Binomial Model
Under one step binomial model we are going to develop a model to
calculate option price. The model valid for both call and put options.
We assume end of the expiration time of stock price can take only
two values. Up jump - or down jump -. It is clear that

𝑆 0 𝑢 ( 𝜔 1= 𝐻 )

𝑉 1( 𝐻 )

𝑆0
𝑉0

𝑆 0 𝑑 ( 𝜔 1=𝑇 )
𝑇 𝑉 1(𝑇 )
 we use following notations.
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T- Expiration time of option (call or put) ,
- Stock price at time 0. (current stock price)
- Value of the option at time
- Payoff at time T.
- payoff if stock has up jump.
- payoff if stock has down jump.
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At Time
 sell a option which value at the time equal to ( the also to be
determined later.
 Buy number of shares ( the also to be determined later)
 Invest in the money market, at risk free interest for the period is .
Wealth of the portfolio is

Therefore at time zero Wealth

(value of the option)
 Then wealth at time is
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Since at time , at time , according to portfolio theory.

Therefore

Since at time T , Stock price has two values then we have two equations

gives
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Let take

Then
 Here
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If is one period interest rate then we use as increment factor for one period but
usually given as continuously compounded interest rate per annum. In the case .
Therefore

is call risk natural probability value.

 Example 5.1
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Consider stock with current price $100 and and ) and expiration time , of option
is months and . Calculate
1. Value of the European call option if strike price is 102.
2. Value of the European put option if strike price is 102.
Answer:
1.
𝑆 0 𝑢=110
𝑉 1 ( 𝐻 ) =8

𝑆 0=100
𝑉 0=?
𝑆 0 𝑑=90
𝑉 1 ( 𝑇 )=0
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Also
 𝑆 0 𝑢=110
𝑉 1 ( 𝐻 ) =0
12 2.

𝑆 0=100
𝑉 0=?

𝑆 0 𝑑=90
𝑉 1 ( 𝑇 )=12

Also
 Note:
Consider
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That is
 If Since denominator is positive then .

14 That is then there is a arbitrage opportunity.

At

Action Cash flow

Borrow money from bank

Buy a Share
 At
Profit (Loss)

Action Cash flow

Return money
thereSell
is ashare
arbitrage opportunity. (minimum value)
Profit (Loss)
 Premium of the American Call Option (non-dividend paying stock)
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Consider you own an American call option with strike price

𝑆0 𝑆𝑡 𝑆𝑇
0 𝑇 −𝑡 𝑇

𝑆𝑡 − 𝐾 𝑆𝑇 − 𝐾

If American call exercise at time

Payoff (you get) at the time =
Assume he deposited it then at time he receive =
Instead of it You short sell a share ( receive money and promise to give share at
time T ) at then at
 If at time American call exercise (if then you receive a share (return it and
16 settle short position) and pay and from bank receive .
Total
If not exercise (if buy a share from open market and return to settle short
position and from bank receive .
Total .
It is clear
When ,
Also When , .
Therefore wait until expiration time is better than the exercise American call
option early for non-dividend paying stock.
Then
for non-dividend paying stock
American call option value= European call option value
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5.3 Premium calculation of the American Put Option

Since American put option can exercise any time point before the expiration time
we consider Binomial model node points are possible exercise points. Then we
compare backward calculate payoff value using Binomial model and the point
payoff and take maximum value. See the next example.
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 Premium Calculation using two step Binomial Model
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European Call/put

American call (non-dividend paying stock)=European call

American put
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Example 5.2
Consider six months European put with a strike price of £32 on a stock with current price £40.
There are two time steps and in each time step the stock price either moves up by 20% or
moves down by 20%. Risk-free interest rate is 10%. Find the current option price.

Example 5.3
Consider six months American put with a strike price of £32 on a stock with current price £40.
There are two time steps and in each time step the stock price either moves up by 20% or
moves down by 20%. Risk-free interest rate is 10%. Find the current option price.
21 Answer Example 5.2:

T 0.5
57.6
K 32 0
S0 40
n 2 48
0
u 1.2
d 0.8 40 38.4
r 0.1 1.161063 0

∆T 0.25 32
exp(r*∆T) 1.02531512 2.725950311
exp(-r*∆T) 0.97530991 25.6
q 0.5632878 6.4
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5.4 Valuing Options Numerically Using Binomial Trees

The binomial model for a non-dividend – paying stock
A more realistic model is one that assumes stock price movements are composed of a
large number of small binomial movements. Consider the evaluation of an option on a non-
dividend – paying stock. We start by dividing the life of the option into a large number of
small time intervals of length
In practice life T of the option is divided into a large number of small time intervals, of length
(Mostly 30 or more steps)
(With 30 time steps, there are 31 terminal stock prices and possible stock price paths.)
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5 Determination of u and d
The unknown values are u and d. In practice, these are taken to be . Where the
standard deviation of the proportional is change in the stock price in a short time period
of length and is obtained from historical data on the stock price

Proportional variance of from is given by

5.6 Estimating Volatility from Historical Data
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The volatility of a stock price is the standard deviation of the return provided by the
stock in one year when the return is expressed using continues compounding. As a rough
approximation is the standard deviation of the proportional change in stock price at time T.
The record of stock price movements can be used to estimate volatility. The stock price is
usually observed at fixed interval of time.

Let : number of observations

- Stock price at end of ith interval (
– Length of time interval in years
Let
Standard Deviation of ’s =
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Or
Standard deviation of the is. Therefore
The calculation based on non-dividend paying stock
For the dividend paying stocks
Take as , during the time interval ex-dividend payment include
The return in other time intervals still
It is probably best discard the ex-dividend day time interval.
 If data daily stock prices then
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If data weekly stock prices then

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Example 5.5:
Consider a five month European call option on a non
dividend paying stock the initial stock price is $50, the strike
price is $50, the risk free interest rate is 10% per annum and
the volatility is 40% per annum. Construct five step binomial
model considering = 1 month.
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Example 5.6:
Consider a five month American put option on a stock . The initial stock price is
$50, the strike price is $50, the risk free interest rate is 10% per annum and the
volatility is 40% per annum. Construct five step binomial model considering = 1
month.
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The Binomial Model for a Dividend – Paying Stock
As a result of dividend paying of stock deduce at ex-dividend date.
Assume known dividend yield is to be paid at a certain time in the future. (See figure )
If the time prior to the stock going ex-dividend, the nodes on the tree correspond to
stock prices

If the time is after the stock goes ex-dividend, the nodes correspond to the stock prices
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A rather more realistic assumption is that the dollar amount of the dividend rather than the
dividend yield is known in advance. Under the dollar amount of dividend payment, number
of nodes increases. (Double after the dividend payment). To simplify the difficulty we
assume the stock price has two components, a part that is uncertain and a part that is the
present value of all future dividends during the life of the option.
Suppose there is only one dividend payment date, during the life of the option and that
The value of the uncertain component , at time is given by

Define as the volatility of , and assume the rather than is constant.

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With replaced by , a tree can be constructed in the usual way to model , by adding to
the stock price at each node the present value of future dividends ( if any) the tree can be
converted into another tree that model at time , the nodes on this tree correspond to the
stock prices.
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Example 6.5:
Consider a five month American put option on a stock that is expected to pay a single
dividend of $2.06 during the life of the option. The initial stock price is $52, the strike
price is $50, the risk free interest rate is 10% per annum and the volatility is 40% per
annum and ex-dividend date is in 3.5 months. Construct five step binomial model
considering = 1 month.
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Q9. Consider the two step binomial model of European call option with . Let is step
payoff when share price is equal to and is number of shares of hedging portfolio when
outcome y. Calculate the followings,

(i) Risk natural probability, (ii) (iii)

(iv) (v) (vi)

(vii) Why is negative? Explain.