Option Pricing II
Binomial Option Pricing
Consider a world with a risky stock and a riskfree
bond.
Let the riskfree return be r-1.
Let the stock give a return u - 1 with probability q
and a return d - 1 with probability 1 - q.
It is easy to see that u > r > d.
uS
q
S
1-q
dS
Binomial Option Pricing
uS
q
S
1-q
dS
Cu Max0, uS K
q
C
1-q
Cd Max0, dS K
Binomial Option Pricing
To get a handle on the value of this call option, we
attempt to construct an equivalent portfolio of
the underlying stock and the riskfree bond.
If we are able to construct such a portfolio, we can
value it, and, given no-arbitrage, value the call
option.
Buying stock and then leveraging the position by
borrowing at the riskfree rate may help.
Suppose we buy D stocks and B bonds. What is
our payoff?
Binomial Option Pricing
DuS+rB
q
DS+B
1-q
DdS+rB
Cu
q
C
1-q
Cd
Binomial Option Pricing
For the two portfolios to be equivalent, we must have:
D uS rB Cu
D dS rB Cd
Solving for the unknowns D and B we get:
C Cd
D u
u d S
uCd dCu
B
u d r
Binomial Option Pricing
With no arbitrage, the following must hold:
C DS B
Cu Cd uCd dCu
S u d r
u d S
1 r d ur
Cu Cd
r ud u d
Binomial Option Pricing
C
1
r
p Cu 1 p Cd
where
rd
p , and
ud
ur
ud
1 p
Binomial Option Pricing
C
1
r
p Cu 1 p Cd
where
rd
p , and
ud
ur
ud
1 p
Note that q does not appear here and investors
agree on the relation between C, S and r.
The value of the call is free of investors attitude
toward risk.
Example
Suppose DEC's current share price is $87. A call
option on DEC with exercise price $90 matures in
2 weeks.
You believe that DEC's performance over the next
two weeks is closely linked with the housing starts
report. A positive report could mean a stock price
as high as $94 at option maturity and a negative
report could mean a price as low as $83.
If the riskfree rate over two weeks is 0.3%, price
the call option. Obtain D and B.
Solution
We have d = 0.954, u = 1.081, r = 1.003. Why?
Cu = 4, Cd = 0. Explain.
D = ? and B = ?
D = 0.362 and B = -29.957.
Therefore, the equivalent portfolio requires that you buy
$31.494 worth of stock and borrow $29.957 to finance part
of the purchase. This requires you put in $1.537.
If stock price hits $83, your position is worth zero. If it
hits $94, your position is worth $4.
What is C then? C = 0.362 x 87 + (-29.957) = $1.537.
Option Pricing: Two Subperiods
Cuu Max 0, u2 S K
Cu
C Cud Max0, udS K
Cd
Cdd Max 0, d 2 S K
Option Pricing: Two Subperiods
Cu
1
r
p Cuu 1 p Cud
Cd p Cud 1 p Cdd
1
r
r
1
C 2 p2 Cuu 2 p 1 p Cud 1 p Cdd
2
C 2
1
p2 Max 0, u2 S K 2 p 1 p Max0, udS K
r 1 p2 Max 0, d 2 S K
Option Pricing: n Subperiods
1 n
C n
n!
p 1 p
r j 0 j ! n j !
j n j j
Max 0, u dn j
S K
n n j u d
j n j
p 1 p
n!
C S j
j 0 j ! n j ! r n
n n j
p 1 p
n n!
Kr j
j 0 j ! n j !
Black Scholes Model
C S N d1 Kr n N d2
d1
ln S K r 2 2 T
T
d2 d1 T
N d1, N d1 = cumulative normal probabilities
2 = annualized variance of the
continuously compounded return
r = continuously compounded risk - free rate
Example
Suppose CBS's current share price is $164.
A call option on CBS with exercise price $165
matures in 35 days.
Also suppose annualized variance of stock return
is 0.0841.
Finally, riskfree rate based on a T-Bill with 30
days to expiration is 5.35%.
What is the theoretical price of the call option?
Solution
Continuously compounded rate ln(10535
. ) 0.0521
= 0.29
ln164 / 165 0.0521 0.0841 / 2 0.0959
d1 0.0328
0.29 0.0959
d2 0.0328 0.29 0.0959 0.0570
N d1 N 0.0328 0.5120
N d2 N 0.0570 0.4761
C 164 0.5120 165 e 0.0521 0.0959 0.4761 5.803
