# One Period Binomial Model

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1 FIN FINANCIAL INSTRUMENTS SPRING 2008 One Period Binomial Model These notes consider the one period binomial model to exactly price an option. We will consider three different methods of pricing an option: deltahedging, creating a synthetic option using the underlying asset and the riskfree asset and calculating the risk-neutral probabilities or stochastic discount factors. All methods will be used again when we extend the binomial model beyond one period and when we consider continuous trading. Keywords: Delta-hedging, synthetic options, replication, risk-neutral probabilities, risk-neutral valuation. Reading: Start of chapter 11 from Hull. Binomial Model To value options exactly it is necessary to make specific assumptions about the determinants of the price of the underlying security. In practice this often means that a continuous stochastic process for the underlying is estimated or inferred from observations on past prices. However, the essential aspects can all be embodied in a simple binomial model in which the underlying asset can be one of two possible values at the end of each period; to put in starkly the asset can either go up or go down in value. By considering more than one period a binomial tree is constructed, where the price that an asset has branches out, either upward or downward at each point in time. These binomial trees can provide a remarkably good approximation to a more complex stochastic process provided that the number of periods is reasonably large, say above thirty. 1

2 2 ONE PERIOD BINOMIAL MODEL In fact nearly all the basic principles of derivative pricing can be explained with a one or two period binomial model and this section develops the one period binomial model to study how options are exactly priced and the riskiness and elasticity of options. Delta Hedging Buying a stock is a risky investment. Buying a call option on that stock is even riskier. Yet combining the stock with the option can produce an investment that is risk-free. That is it is possible to hedge a position in the stock by taking an opposite position in the call option. To create such a risk-free investment it is necessary to buy the stock and the option in exactly the right proportions. The number of units of the stock required per option is known as the (Delta) of the stock and taking these positions to create a risk-free investment is known as Delta Hedging. We will now illustrate how to calculate in a simple binomial example. Once is known the option price itself can be calculated as any risk-free investment must in the absence of arbitrage opportunities earn the risk-free rate of return. Consider a simple example where the price of the underlying stock is 100 and at the end of three months it has either risen to 175 or has fallen to 75. There is an up state and a down state. Let u = 0.75 and d = 0.25, so that the value of the stock in three months in the up state is 100(1+u) = 175 and the value in the down state is 100(1 + d) = 75. The net growth rate of the value of the stock in the up state is 75%, and the net growth in the value of the stock in the down state is 25%. Since the stock can either rise by 75% or fall by 25% buying the stock is a risky investment. Now consider an at the money call option on this stock with a strike price of 100. If the stock goes up then in three months the

3 FIN FINANCIAL INSTRUMENTS 3 call can be exercised for a profit of = 75 and if the price of the stock goes down, then the call will not be exercised. Thus the payoff to the call option is 75 in the up state and 0 in the down state. So the call is also risky. Suppose however, that we consider buying units of the stock and writing one call. The payoff from this portfolio is in the up state: the stock has gone up to 175 but the call option we have written will be exercised against us so we have an obligation of 75 The payoff in the down state is simply 75 as the call option is not exercised in the down state. To make this portfolio risk-free it is necessary to choose such that = 75 so that the payoff is the same no matter whether we are in the up state or the down state. Solving for gives = 3/4. Thus to completely hedge out the risk in the stock, we should sell four call options for every three units of stock we buy. The payoff from such a portfolio is given in Table 1. The value in three months time is 225 in both states and hence the portfolio is riskfree. Since it is risk-free it can be valued using the risk-free rate of interest. Suppose the risk-free rate of interest is 1/4 or 25%. The present value of this portfolio is 225/(1 + 1/4) = 180. The value of the portfolio now is simply the current value of the share, = 300 less 4c where c is the price of the call option. If there are no arbitrage possibilities then the value of this portfolio must also have a value of 3180: 300 4c = 180. So solving for the call price gives c = 30. This shows that the -hedge can be used to price the option. The same procedure can be generalized. Let S be the value of the underlying stock, so its terminal value is S u = (1 + u)s in the up state and S d = (1 + d)s in the down state. Let K be the strike price of the option and c u = max[0, S u K] be the value of the call option in the up state and

4 4 ONE PERIOD BINOMIAL MODEL Position Value Now Value in down state Value in up state 4 Short Calls 4c Long Shares Overall 300 4c Table 1: Risk-Free Portfolio - Example c d = max[0, S d K] is the value of the call option in the down state. Remember, that the call option gives us the right to buy the underlying at a price of K, so for example in the up state when the stock is worth S u, the option gives the right to buy at K and asset that can be sold for S u. Thus the option will be exercised for a profit of S u K if S u K > 0 and won t be exercised otherwise. Now consider the -hedge portfolio that writes one call and buys units of the underlying. The payoffs from this portfolio are given in Table 2. The value of is chosen so that the portfolio is riskless, S d c d = S u c u, i.e. = c u c d S u S d = c u c d (u d)s. The value of the risk-free portfolio is evaluated at the risk-free rate of interest r, so that S c = S d c d (1 + r). Using the value of just derived, and substituting (1+d)S for S d and solving for c gives after some manipulation c = pc u + (1 p)c d (1 + r) where p = (r d)/(u d). Thus for any values of S, K, r, u and d, the value of the call option can be calculated from this formula. There is a natural interpretation for. It is the difference in the value of the call at maturity c u c d in the up state rather than the down state

5 FIN FINANCIAL INSTRUMENTS 5 Position Value Now Value in down state Value in up state Short Call c c d c u Long Shares S S d us u Overall S c S d c d S u c u Table 2: Risk-Free Portfolio relative to the difference in the value of the stock S u S d. It tells us the change in the value of the call relative to the change in the value of the stock or how much the value of the call changes when the stock changes by a given amount. Thus tells us how responsive is the call value to changes in the value of the stock. We will return to this interpretation when we consider the elasticity of an option later on. Synthetic Options The idea underlying -Hedging is to create a risk-free asset using a combination of the stock and the option that can be valued at the risk-free rate of interest. The risk-free asset and the underlying asset can themselves be combined to replicate the payoffs of the option itself. Such a combination is called a synthetic option. Consider again our simple example where the price of the underlying stock is 100 and at the end of three months it has either risen to 175 or has fallen to 75. Now consider how an at the money call option on this stock with a strike price of 100 can be synthesized. The payoff to the call option in the up state is 75 and the payoff in the down state is 0 as the option will not be exercised. Consider buying units of the stock and investing B units of funds at the risk-free interest rate of 1/4. The payoff from this portfolio in the up state is (1 + 1/4)B and the payoff in the down state is 75 + (1 + 1/4)B. To synthesize the option we must match these payoffs to

6 6 ONE PERIOD BINOMIAL MODEL Position Value Now Value in down state Value in up state Borrow B /4 225/4 Buy shares /4 525/4 Overall Table 3: Synthetic Option the payoffs from the option. That is we must find and B to solve (1 + 1/4)B = (1 + 1/4)B = 0. Solving these two equations simultaneously gives = 3/4 and B = 45. Thus the option can be replicated by borrowing 45 and buying 3 units of the 4 stock. Since the stock costs 100 the the cost of buying 3/4 of a unit of stock is 75. Thus the net cost of synthesizing the option is the price we pay minus the amount borrowed, = 30. Again the portfolio that replicates or synthesizes the call must have the same price as the call itself. Hence c = 30 and we reach exactly the same conclusion as before. The payoffs are summarized in Table 3. Again it is simple to generalize this procedure. To find the number of shares to be bought and the amount to invest B to synthesize the option it is only necessary to solve simultaneously the following two equations: S u + (1 + r)b = c u S d + (1 + r)b = c d. Solving these two equations gives and = c u c d S u S d B = r (c d S d ) = 1 ( c d (1 + d)s(c ) u c d ). 1 + r (S u S d )

7 FIN FINANCIAL INSTRUMENTS 7 This is illustrated graphically in Figure 1. The payoff at maturity to the call option is illustrated by the thick line. The two possible end values for the stock S u and S d are drawn on the horizontal axis. The strike price K has been chosen between the two values S u and S d so that in the down state the call option expires valueless and c u = 0. The value of the call in the up state is c u = S u k and this is illustrated on the vertical axis. Also drawn is the line connected the two points (S d, c d ) and (S u, c u ). The slope of this line is and the intercept with the vertical axis is S d = (1 + r)b. It can be seen that the line is never downward sloping, so 0 and the slope is always less than 45 o, so 1. 1 The intercept with the vertical axis is zero or negative indicating that the portfolio that synthesizes the call option involves borrowing (selling rather than buying the risk-free asset). The cost of synthesizing the option is the cost of the portfolio of units of the shares and investing B in bonds c = S + B = pc u + (1 p)c d (1 + r) where p = (r d)/(u d) exactly as before. EXERCISE: Repeat for a put option. Risk Neutral Pricing The previous two subsections have derived a simple expression for the price of the call option c = pc u + (1 p)c d. (1 + r) In this expression the value of the call option is the present value of a weighted average of the call at maturity, either c u in the up state, or c d in the down state. It is tempting to interpret p in this equation as a probability. It is 1 It is only equal to zero if c u = c d = 0 and is only equal to one if c u > c d > 0.

8 8 ONE PERIOD BINOMIAL MODEL Payoff Call option C u Slope = Δ = (C u -C d )/(S u -S d ) C d S d K S u S T -(1+r)B Figure 1: The of a Call Option in the Binomial Model important to notice two things about this formula. First p cannot be the probability of an up movement in the stock as the probabilities of stock movements were not used in the calculation of the call value. Thus the value of the call is independent of the probabilities of the up or down movements in the stock price. Second the formula for the call is based on the present value of pc u + (1 p)c d and is therefore valued as if this payoff was risk-free. Thus the probability p is a risk-adjusted probability. It is simply the future value of the state price for the up-state. To give an interpretation to p imagine a situation where all individuals were indifferent to risk. Such as situation is known as a risk-neutral world. In such a situation all individuals would agree to value any risky prospect

9 FIN FINANCIAL INSTRUMENTS 9 simply by its expected present value. Since the formula for the value of the call is the expected present value when p is interpreted as the probability of an upward movement in the stock, ρ is interpreted as a risk-neutral probability and this method of valuing the derivative is called risk neutral valuation. It is a simple and general principle that can be used for valuing all derivative securities. To see how it can be used, let s revisit our simple example again. Using the method of risk neutral valuation, the expected value of the stock at the end of the period is 175p + 75(1 p), so the expected present value using the risk-neutral probabilities is 175p + 75(1 p). (1 + 1/4) This must equal the actual value of the stock which is 100. This gives one equation in one unknown, p, and solving gives p = 1. To value the call we 2 simple use risk-neutral valuation again. The call at maturity is worth 75 in the up state and 0 in the down state, so the expected value using the risk neutral probabilities is (1/2)75 and the present value of this expectation is (1/2)75/(5/4) = 30. Again generalising this method, p is solved from the equation S = p(1 + u)s + (1 p)(1 + d)s (1 + r) to give p = (r d)/(u d) exactly as before and this value of p can then be used to compute the risk-neutral valuation for the option. Summary We ve considered a one period binomial model where the stock price can go either up or down by factors (1 + u) and (1 + d). We can the use information

10 10 ONE PERIOD BINOMIAL MODEL on the current stock price S, the risk-free interest rate r and the strike price K to determine the value of the option. We did this in three different ways. First by creating a riskless portfolio of the stock and the option. Second by creating a synthetic option that replicates the payoffs to the option using the underlying stock and the risk-free asset. In both cases we use an arbitrage argument that any two portfolios or assets that deliver the same payoffs must trade at the same price. Thirdly we derived the risk-neutral probability such that all assets and portfolios are valued by their expected present value. This ten allows the option to be evaluated in the same way using these riskadjusted probabilities. The next thing to do is to allow for more than one period in the binomial model to see if the price of the option can still be calculated in a similar and similarly simple fashion.

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