FI 3 07 – CLASS 2 3

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BINOMIAL TREES

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TOPICS

• Last Wednesday – Basic properties of options

• Monday – Option structures and models
• Wednesday – Models & and applications in corporate finance.
• All material from chapter 8 of Brigham & Erhardt

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C A S E S T U DY – D U E A P R I L 2 8 t h

Case study: Option Greeks, Insider Trading, and the Heinz Acquisition
https://store.hbr.org/product/option-greeks-insider-trading-and-the-heinz-acquisit
ion/UV8265

• The case study will be handed in during class on April 28th, giving a few extra
days to complete.
• Assignment (including questions to be answered) posted to Brightspace.

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O P T I O N N O TAT I O N

Current value of call option

Current price of underlying stock
Probability that a deviation less than will occur in a standard normal
distribution. Thus, and represent areas under a standard normal distribution
function
Strike price of the option
Risk-free interest rate
Time in years until option expires
Natural logarithm of P/X
Standard deviation of rate of return on stock

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BINOMIAL MODEL BASICS

• Binomial probability distribution – a distribution where there are two

possible outcomes or states. Also called a two-state model.
• Binomial models can be used to value an option after a single unit of time, or
across multiple discrete periods.

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F I R S T, C O N S I D E R O N E - P E R I O D B I N O M I A L T R E E

T=0 T=1

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I N P U T S T O B I N O M I A L M O D E L & N O TAT I O N

A binomial model will require the following inputs:

• Current stock price
• Exercise price
• The amount it can go up in one period, called u
• The amount it can possibly go down in one period d
• The prevailing interest rate

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I N P U T S T O B I N O M I A L M O D E L & N O TAT I O N ( P 3 4 0 )

For example, consider a stock worth $40 that could increase in price by 25% or
decrease in price by 20%. If there were a $35 strike call option available, you
would have:
• Current stock price = $40
• Exercise price = $35
• The amount the stock can go up in one period, called u = 1.25
• The amount the stock can possibly go down in one period d = .80
• The given prevailing interest rate = 8% or 0.08
• Time in years until option expires given as 6 months, or 0.5 years

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PAT H O F U N D E R LY I N G A N D $ 3 5 S T R I K E O P T I O N

STOCK PRICE PATH P(u)

P(d)

CALL OPTION PRICE PATH 𝑪𝑼

𝑪𝑫
T=0 T=1 10
PAT H O F U N D E R LY I N G A N D $ 3 5 S T R I K E O P T I O N

STOCK PRICE PATH P(u) = $40 * 1.25 = $50.0

P(d) = $40 * .8 = $32.00

CALL OPTION PRICE PATH = ???

= ???
T=0 T=1 11
PAT H O F U N D E R LY I N G A N D $ 3 5 S T R I K E O P T I O N

STOCK PRICE PATH P(u) = $40 * 1.25 = $50.0

P(d) = $40 * .8 = $32.00

CALL OPTION PRICE PATH = $50 - $35 = $15.00

= $0
T=0 T=1 12
D E T E R M I N I N G T H E VA LU E O F C A L L O P T I O N C AT T
= 0

• To determine the value of call option C at T = 0 construct a riskless portfolio of

stock and options.
• Determine the number of shares held that will have the same payoff whether
the stock goes up or down, creating a hedge portfolio.
• Use the hedge portfolio to help determine the value of the option.
• A riskless portfolio should earn the risk-free rate of return .
• Given the stock’s values and the riskless rate of return can derive call value
from other available variables.

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T H E H E D G E P O RT F O L I O A N D H E D G E R AT I O

The number of shares of stock required to create the hedge portfolio can be
determined by:

Using our current example:

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T H E H E D G E P O RT F O L I O PAYO F F

The number of shares of stock required to create the hedge portfolio can be
determined by:

If the stock is up, payoff of portfolio is: - or 0.83333($50) - $15 = $26.6665

If the stock is down, payoff of portfolio is: - or 0.83333($32) - $0 = $26.6665

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T H E P R E S E N T VA LU E O F H E D G E P O RT F O L I O
PAYO F F

Because the hedge portfolio’s future payoff is riskless (same value if up or down),
the current value of the hedge portfolio must be equal to the present value (PV) of
its riskless payoff. Prevailing interest rate = 8% or 0.08 compounded daily & that
the option expires in = 6 months, or 0.5 years.
The present value (PV) of the hedge portfolio’s riskless payoff of $26.6665 in 6
months is:
N = .5(365)
I/YR = 8/365
PMT = 0
FV = -$26.6665
PV =

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T H E P R E S E N T VA LU E O F H E D G E P O RT F O L I O
PAYO F F

Because the hedge portfolio’s future payoff is riskless (same value if up or down),
the current value of the hedge portfolio must be equal to the present value (PV) of
its riskless payoff. Prevailing interest rate = 8% or 0.08 compounded daily & that
the option expires in = 6 months, or 0.5 years.
The present value (PV) of the hedge portfolio’s riskless payoff of $26.6665 in 6
months is:
N = .5(365)
I/YR = 8/365
PMT = 0
FV = -$26.6665
PV = $25.621 which equals current value of components of hedge portfolio

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F I N D I N G A N O P T I O N ’ S VA LU E

The current value of the hedge portfolio is the value of the stock less the value
of the call option written:

Current value of hedge portfolio =

Because payoff is riskless, current value of hedge portfolio must equal to the
present value of the riskless payoff:

Current value of hedge portfolio = Present value of riskless payoff

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F I N D I N G A N O P T I O N ’ S VA LU E

Because payoff is riskless, current value of hedge portfolio must equal to the
present value of the riskless payoff:

= Present value of riskless payoff

= Present value of riskless payoff

= 0.83333($40) - $25.621
= $7.71

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H E D G E P O RT F O L I O S & R E P L I C AT I N G P O RT F O L I O S

Instead of combining a share of stock with a written call option, can create a portfolio
that replicates the call option’s payoffs.
• Purchase .83333 shares of stock and borrow $25.621 at the risk-free rate
• In 6 months, repay future value of borrowed $25.621, calculated by N = 0.5(365),
I/YR = 8/365, PV = -$25.621, PMT = 0 and solve for FV = $26.6665

If stock goes up, net payoff is .83333($50) - $26.6665 = $15.00

If stock goes down, net payoff is .83333($32) - $26.6665 = $0

Replicating portfolio matches option’s payoffs with cost 0.83333($40) - $25.621 =

$7.71

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SINGLE PERIOD BINOMIAL OPTION PRICING
FORMULA

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SINGLE PERIOD BINOMIAL OPTION PRICING
FORMULA

Applying this to the $35 call option we have been working with so far:

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W H AT W E A R E N O T C O N S I D E R I N G

The probability of a move upward and downward is assumed to be 50% up, 50%
down.

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BINOMIAL OPTION PRICING FORMULA WITH
PRIMITIVES

In the binomial option pricing model, a large portion of the calculation relies on
variables that do not relate to the option itself, like the up and down trajectory
of the stock, risk-free rate, and periods to expiry.
Can separate that portion of the equation into two primitive securities and ,
which simplifies the calculation if being repeated multiple times.

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C A L C U L AT I N G U S I N G P R I M I T I V E S E C U R I T I E S

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C A L C U L AT I N G U S I N G P R I M I T I V E S E C U R I T I E S

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C A L C U L AT I N G W I T H P R I M I T I V E S E C U R I T I E S

Which yields the simplified equation:

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C A L C U L AT I N G W I T H P R I M I T I V E S E C U R I T I E S

Using primitive securities allows us to calculate the values of different options

easily. Using the same primitive securities and the following formula, a $30 call
instead of a $35 call with the same u = $50 and d = $32 single-period
underlying tree would be valued.

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C A L C U L AT I N G W I T H P R I M I T I V E S E C U R I T I E S

Using primitive securities allows us to calculate the values of different options

easily. Using the same primitive securities and the following formula, a $45 call
instead of a $35 call with the same u = $50 and d = $32 single-period
underlying tree would be valued.

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C A L C U L AT I N G W I T H P R I M I T I V E S E C U R I T I E S

Using primitive securities allows us to calculate the values of different options

easily. Using the same primitive securities and the following formula, a $45 call
instead of a $35 call with the same u = $50 and d = $32 single-period
underlying tree would be valued.

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E X T E N D I N G T O A M U LT I - P E R I O D B I N O M I A L T R E E

A single period model is not terribly realistic, unfortunately, and does not
accurately represent most valuation scenarios.
• Dividing time into more periods increases realism.
• Will keep stock return’s annual standard deviation constant, regardless of how
many periods.

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S TA RT W I T H N E W u A N D d PA R A M E T E R S

For a multi-period model, will calculate u and d with:

• Annualized standard deviation of stock’s return

• Time in years until expiration and number of periods to expiration

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C A L C U L AT I N G N E W u A N D d PA R A M E T E R S

Keeping with the same example, take as a given that the standard deviation of
the company’s returns is .313373 and one period to expiry:

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C A L C U L AT I N G N E W u A N D d PA R A M E T E R S

Keeping with the same example, take as a given that the standard deviation of
the company’s returns is .313373 and changing to two periods to expiry:

First, use these u and d values to populate the binomial tree of underlying
prices, then solve for option price using them.

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 F I R S T C A L C U L AT E P E R I O D 1 C H A N G E S U S I N G u , d

STOCK PRICE PATH

P= $46.84

P= $40

P= $34.16

T=0 T=1 T=2

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 T H E N C A L C U L AT E P E R I O D 2 C H A N G E S U S I N G u , d

STOCK PRICE PATH P= $54.84

P= $46.84

P= $40
P= $40

P= $34.16

P= $29.17
T=0 T=1 T=2
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T H E N , C A L C U L AT E PRIMITIVE SECURITIES ,

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 U S E PAYO U T S , P R I M I T I V E S & E Q UAT I O N F O R $ 3 5
CALL

STOCK PRICE PATH P= $54.84

P= $46.84

P= $40
P= $40

P= $34.16

P= $29.17
T=0 T=1 T=2
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 S TA RT W I T H E N D S TAT E S F R O M PAYO U T S F O R T =
2

C(u,u)= $19.84
STOCK PRICE PATH P= $54.84

P= $46.84

C(u,d)= $5.00
P= $40
P= $40

C(d,d)= $0.00
P= $34.16

P= $29.17
T=0 T=1 T=2
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 T H E N U S E P R I M I T I V E S T O C A L C U L AT E T = 1
VA LU E S

C(u,u)= $19.84
𝜋 𝑑 =0.46620 STOCK PRICE PATH P= $54.84
𝑉 𝐶 =𝐶𝑢 𝜋 𝑢 + 𝐶 𝑑 𝜋 𝑑 𝐶 𝑢 ¿ 𝐶(𝑢 ,𝑢) 𝜋𝑢 +𝐶(𝑢, 𝑑)𝜋 𝑑
P= $46.84

C(u,d)= $5.00
P= $40
P= $40

C(d,d)= $0.00
P= $34.16
𝐶 𝑑 ¿ 𝐶(𝑑 , 𝑢) 𝜋 𝑢 +𝐶(𝑑, 𝑑)𝜋 𝑑
P= $29.17
T=0 T=1 T=2
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 T H E N U S E P R I M I T I V E S T O C A L C U L AT E T = 1
VA LU E S

C(u,u)= $19.84
𝜋 𝑑 =0.46620 STOCK PRICE PATH P= $54.84
𝑉 𝐶 =𝐶𝑢 𝜋 𝑢 + 𝐶 𝑑 𝜋𝐶
𝑑 𝑢 ¿ 𝐶 (𝑢 ,𝑢) 𝜋 𝑢 + 𝐶 (𝑢 , 𝑑 ) 𝜋 𝑑 = $ 12.53

P= $46.84

C(u,d)= $5.00
P= $40
P= $40

C(d,d)= $0.00
P= $34.16

P= $29.17
T=0 T=1 T=2
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 T H E N R E P E AT T O C A L C U L AT E T = 0 VA LU E S

C(u,u)= $19.84
𝜋 𝑑 =0.46620 STOCK PRICE PATH P= $54.84
𝑉 𝐶 =𝐶𝑢 𝜋 𝑢 + 𝐶 𝑑 𝜋𝐶
𝑑 𝑢 ¿ 𝐶 (𝑢 ,𝑢) 𝜋 𝑢 + 𝐶 (𝑢 , 𝑑 ) 𝜋 𝑑 = $ 12.53

P= $46.84

C(u,d)= $5.00
P= $40
P= $40

C(d,d)= $0.00
P= $34.16

P= $29.17
T=0 T=1 T=2
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I M PA C T S O F I N C R E A S I N G N U M B E R O F P E R I O D S N

The more periods used to build the model, the more realistic the output. The
obvious downside is that the computational burden increases.
• With 2 periods, the value of the option was calculated as $7.64
• With 15 periods, value is $7.42
• With 50 periods, value is $7.39
• With 100 periods, value stays at $7.39

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S U M M A RY - B I N O M I A L T R E E P R I C I N G P R O C E SS

1. Calculate u, d
2. Populate the underlying tree with prices
3. Calculate primitive securities
4. Use primitive securities and option payouts to calculate prices at tree nodes
5. Work backward through tree to arrive at price at T = 0

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S E L F-T E S T P R O B L E M PA G E 3 5 0

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