5 Binomial Trees

Lecture 6:
Binomial Option Pricing Model
This lecture shows that if stock prices move in a

particular way we can replicate the payoff of an option
by dynamically trading the underlying stock and a bond.
We will construct a replicating portfolio of the stock and
a bond that has exactly the same payoff as the option.
By no-arbitrage, the option must then have the same
price as this replicating portfolio.
I. Example
II. Binomial Option Pricing Model
A. Binomial Stock Prices
B. One-Period Model
C. Risk-Neutral Pricing and Probabilities
D. Two-Period Model
III. Dynamic Replication
IV. Multi-Period Models
A. Three-Period Model
B. n-Period Model
Binomial Option Pricing
The option pricing methodology used most on the

street
Developed by Cox, Ross and Rubinstein.

– “Option Pricing: A Simplified Approach”
1979, Journal of Financial Economics
More flexible than Black-Scholes pricing,

– But based on the same key ideas.
– In particular, the use of “replicating portfolios”.
B35100 Page 2 Robert Novy-Marx

We’ve used replicating portfolios in class already.
How did we price a forward contract?

– We constructed a “synthetic forward.”
– I.e., a portfolio of traded assets that has the same
payoffs as the forward.
– Then priced the forward by invoking NA.
We’d like to do the same thing with options.

– But there’s a problem: an option’s payoff is non-
linear in the underlying.
The forward’s payoff was linear in the underlying;
that’s what made replication so easy.
– No (static) portfolio of traded securities (e.g., the
underlying and bonds) is going to have the same
terminal payoff as the option.
So what do we do?

We make a seemingly ridiculous simplification:
We’re going to assume than in the future the stock

will take on one of only two possible prices.
It’s actually not that bad an assumption.
– We’ll justify it in a little while, but first...
I. Example: a stock
Suppose the spot $60. We’re going to assume that
over the next “period” the stock price will
fall to $30,
or rise to $90.
We’ll also assume the risk-free simple interest rate
over the period is 20%.
Su D 90
S D 60
Sd D 30

At the end of this period, a ATM call option (K D $60)

is worth either $0 or $30:
cu D 30
c
cd D 0
Now let’s look at a portfolio

long a half share of the underlying stock,
and short $12:50 in bonds.
90=2 15 D 30
S=2 12:50
30=2 15 D 0
It replicates the call’s payoffs.

What is the portfolio worth initially?

The price of the portfolio is initially
1
$60 $12:50 D $17:50:
2
The portfolio replicates the payoff of the call option,

so the call must, by NA, have the same price, $17:50.
What if the price of the call is $18:50?
Transaction Payoff at t Payoff at T
What if the price of the call is $16:50?
Transaction Payoff at t Payoff at T

How do we “guess” the replicating portfolio?
We need to
buy shares of the underlying,
and borrow D dollars
– i.e., short D worth of bonds,
such that
90 1:2D D 30
30 1:2D D 0:
In the previous example we “guessed” D 0:5 and

D D $12:5 because they solve these two equations,
90 1:2D D 30
.30 1:2D D 0 /
60 D 30 ) D 1=2
) 15 D 1:2D
) D D 12:5:

Option :
Again, the delta of an option is the sensitivity of the

option price to the stock price.
In our example
@C
D
@S
30 15 1
D D
90 60 2
0 15 1
D D :
30 60 2
We know that will always be between 0 and 1.
Remember: in our numeric example,
C0 D 0:5 S0 12:5 D 17:50:
Why is it always be between 0 and 1?
Can we see this graphically?

Payoff Su
Underlying
CK(T)
Sd Cu
Cu - Cd
Cd
Su - Sd
S(T)
The sensitivity of the call to the underlying:
Cu Cd
D
Su Sd
There should also be a short bond position.
The y-intercept isn’t zero.

Why this works

Why can we find a replicating portfolio for the call?
It works because the option payoff is linear in the
underlying if we assume only two possible future
stock prices.
– In technical jargon, the stock and the bond then
span the option’s possible payoffs.
Because there’s a linear relation between the price

of the option and the underlying, we can think about
the sensitivity of the option’s price to the price of the
underlying.
This sensitivity is called the hedge ratio, or
“delta”, of the call.
– That’s why we choose to use the symbol.
We chose such that the replicating portfolio has
the same sensitivity to the stock price as the call
option.

Where do we use the probabilities of the up and down

moves?
Cu Cd
D
Su Sd
We don’t!
Important: The option price we got did not depend

on any probabilities!
At least not directly.
We don’t need the probabilities of the price moves to

compute the option price
Our pricing only depended on NA
– I.e., constructing the replicating portfolio.
– It doesn’t depend on the likelihood of any
outcomes.
– It’s model-independent.
The methodology, not the tree.
Question: why doesn’t the option price depend on

any probabilities, or the expected return of the stock?
What’s the intuition?

If we priced options by discounting future payoffs,

– i.e., like we do with stocks and bonds,
then we would need to use the probabilities of
different outcomes.
But we don’t. We price options as a function of the

stock price, using NA.
– The current stock price already reflects what
can happen to the stock price in the future.
– We don’t need to consider this again in deriving
the relation between the option price and the
stock price.
Does this mean that news which leads to an increase

in the probability of a stock price up-move doesn’t
affect the call price?
Of course not!
– But it affects the call price through its impact on
the current stock price.
Expectations about future prices are embedded
in the current price.

II. Binomial Option Pricing Model

(A) Binomial Stock Prices
Obviously, stock prices can take on more than two
values. However, we can increase the number of
outcomes by shortening each period and taking
more steps. This results in a binomial tree:
Suuu
Suu
Su Suud
S0 Sud
Sd Sud d
Sd d
Sd d d
We’ll argue (in lecture 7) that it’s reasonable to

assume that stock returns are normally distributed.
With enough steps a multi-period tree can
approximate log-normal returns arbitrarily well.
To price an option with a multi-period tree, we
just solve the one-period tree repeatedly. So
we’ll derive the general solution to the one-period
binomial model first.

(B) One-Period Model
The payoffs of the stock are:
Su D uS
S
Sd D dS
where
u D 1 C rgood
d D 1 C rbad :
and rgood and rbad are the returns to the stock when
it goes up and down, respectively.
To prevent arbitrage we’ll also require that
d <1Cr <u
where r is the risk-free borrowing/lending rate.

The payoffs of a call option (at maturity) are:
cu D .uS K/C
c
cd D .dS K/C
where X C maxŒX; 0:
The payoffs of a portfolio with shares of the stock

and D dollars of borrowing are:
uS .1 C r/D
S D
dS .1 C r/D

To replicate the call option we require that:
uS .1 C r/D D cu
dS .1 C r/D D cd
Computing the hedge ratio, or delta, yields:
.uS dS/ D cu cd
cu cd
) D :
S.u d /
If you think of it as
cu cd
D
Su Sd
@c
it makes it clear that D @S
.

The amount of borrowing can be computed from:
uS .1 C r/D D cu
uS cu
) D D :
1Cr
cu cd
Then using D S.u d /
we get

cu cd
.1 C r/D D S.u d /
uS cu
.cu cd /u .u d /cu
D
.u d /
dcu ucd
D :
u d

The call is a levered claim on the underlying.

How do we know this?
Because and D are always positive:
cu cd
D
S.u d /
0;
and
dcu ucd
D D
.1 C r/.u d /
.duS dK/C .udS uK/C
D
.1 C r/.u d /
0:
Therefore, the replicating portfolio for a call on a

stock consists of
a long position in the stock, which is
partially financed through borrowing.

Question:
What is the replicating portfolio of a put option with
payoffs pu and pd ?
Replicating the put requires
uS .1 C r/D D pu
dS .1 C r/D D pd
pu pd
) D :
S.u d /
Then uS .1 C r/D D pu )
dpu upd
.1 C r/D D :
u d
Just like for the call, only now 0 and D 0.

The replicating portfolio for the put is a levered
short position in the underlying.

Numeric Example: Intel is priced at 20

Next period will either be priced at 18 or 23
The simple, one-period risk-free rate is 8%
What’s the price of the one-period ATM call?
Well, what is the price of the replicating portfolio?
How much Intel is it long?
How big is the debt position?
So what’s it worth?

(C) Risk-Neutral Pricing and Probabilities
“Risk-neutral pricing” is a methodology that

simplifies everything we’ve been doing.
We’re going to develop it three different ways
1. As an algebraic convenience.
– This is the “easiest” way to think about it.
– But you don’t really learn anything.
It ignores all the economic content.
It doesn’t help us when we want to do the
same things in a more realistic setting.
2. As pricing in a “risk-neutral” world.

– This is how it developed historically.
It is quite powerful, and provides intuition.
3. As a better way to replicate.

– This methodology hints at the most powerful
tools in modern finance.
It really involves calculating “state prices.”

1. R-N Pricing as an algebraic convenience.

Remember: we priced the call by constructing,
and then pricing, the replicating portfolio,
c D S D
where
cu cd
D
.u d /S
dcu ucd
D D :
.1 C r/.u d /
Substituting for and D gives the call price as

a function of
1. The tree “primatives”: u, d , and r
2. The next-period payoffs: cu and cu
cu cd dcu ucd
c D
u d .1 C r/.u d /
.1 C r/.cu cd / .dcu ucd /
D :
.1 C r/.u d /

There was nothing special about the call.

– The same methodology works for any asset.
So for any asset V
.1 C r/.Vu Vd / .dVu uVd /

V D
.1 C r/.u d /
where Vu and Vd are the asset value next

period in the up and down states for the
underlying.
Now do some algebra

1 .1 C r d /Vu C .u .1 C r//Vd
V D
1Cr .u d /

1Cr d
u .1Cr/
u d
Vu C u d
Vd
D :
1Cr

Finally, if we define, as an algebraic convenience,
.1 C r/ d
q ;
u d
then

1Cr d
u .1Cr/
u d
Vu C u d
Vd
V D
1Cr
qVu C .1 q/Vd
D :
1Cr
What does this “say”?
It says
Q
Et VtC1
Vt D :
1Cr
Q
where Et Œ means expectation assuming the
stock goes up with probability q. (Note: q ¤ p!)

That is, the call’s price is just the discounted

“expected” payoff of the option.
– Here “expected” payoff “assumes” that the
stock goes up with probability q.
Of course, that isn’t “really” the probability of
an up move.
We have not actually said (or assumed)
anything about the “real” probability yet.
We call q the risk-neutral probability of the

stock price up-move,
– or sometimes the “pseudo probability”.
We call the true probability, p, the objective

probability,
– or sometimes the “physical probability”.
Why do we call q the risk-neutral probability?

– We’ll get back to this in a little while.

Important for us: it makes pricing easier.
qcu C .1 q/cd
c D
1Cr
where
.1 C r/ d
q D
u d
It’s easier than calculating, and then pricing,

the replicating portfolio
– Even when we have formulae for the stock,
bond positions in the replicating portfolio
c D S D
where
cu cd
D
.u d /S
dcu ucd
D D :
.1 C r/.u d /

Intel example redux

Whats the price of the ATM call?
Remember:
– S D 20
– Price next period is 18 or 23
– Simple, one-period rate is 8%

2. R-N pricing in a “risk-neutral world”.
For a minute, let’s forget entirely about the

“real world”.
– The “real world” in which:
We see S, u, d , and r.
People are risk-averse.
Let’s hypothesize a fictional world.

– In this fictional world:
Everyone is risk-neutral.
We see the exact same S, u, d , and r.
– How can that be?
p must be different in this fictional world.
Question: what is the price of a call in this

fictional, risk-neutral world?
– It must be exactly the same as in the “real
world”!
Why?

No-arbitrage considerations imply the relation

between the option’s price and S, u, d and r.
– For example, we saw
c D S D
where
cu cd
D
S.u d /
dcu ucd
D D :
.1 C r/.u d /
By assumption, S, u, d and r are exactly the

same in the risk-neutral world.
No-arbitrage relationships are independent of

investors’ risk preferences
) the same pricing relationship holds in a
fictitious world in which:
– Prices are the same.
– Investors are risk-neutral.

Question: How do we compute the price of an

option (or any asset) in a risk-neutral world?
We could replicate the payoffs by constructing

the replicating portfolio.
– But we don’t have to!
Pricing options in this fictitious, risk-neutral

world is easier.
– Pricing any asset is easier.
– We can “forget” that we’re replicating payoffs.
Asset price are discounted, expected payoffs:
q cu C .1 q/ cd
c D
1Cr
q pu C .1 q/ pd
p D ;
1Cr
where q is the probability of the up-move in the

risk-neutral world.

But what is q, the probability the stock price

goes up?
– Everyone’s risk-neutral
– Expected return to the stock = risk-free rate:
quS C .1 q/dS D Et ŒStC1 D .1 C r/S:
So
qu C .1 q/d D 1Cr
.1 C r/ d
) q D :
u d
Once we have the risk-neutral probabilities, it’s

easy to price any asset.
– Not just options, though they are what we’re
interested in, primarily.

That is, in the risk-neutral world, given any

asset V ,
q Vu C .1 q/ Vd
V D ;
1Cr
where Vu and Vd are the payoffs to the

asset when the stock goes up and down,
respectively.
So, in the risk-neutral world
q cu C .1 q/ cd
c D
1Cr
where
.1 C r/ d
q D :
u d
But what does this tells us about c in the “real

world”?

It tells us exactly the price of the call in the “real

world”!
q cu C .1 q/ cd
c D
1Cr
where
.1 C r/ d
q D :
u d
Remember, we assumed prices in this risk-

neutral economy were exactly the same as
those we observe in the real economy.
Ultimately, the option price in the risk-neutral

economy just depends on NA.
– We could construct replicating portfolio.
They only depend on prices.
They don’t depend on risk preferences at all.
So options priced the same in the real world.

– Same replicating portfolios in both worlds.
– Same prices for the assets in the replicating
portfolios in both worlds.

3. R-N Pricing as a better way to replicate.

Again: we priced the call by constructing, and
then pricing, the replicating portfolio,
c D S D:
Here is you holdings in the stock, and

D=.1 C r/ is your holdings in the bond.
– But and D aren’t immediately obvious.
It would have been a lot easier to replicate the

call with:
1 0
Au Ad
0 1
You don’t even have to stop to think,
c D cuAu C cd Ad :

We don’t have Au and Ad though, you say?

But we can construct them!
– How?
We replicate them.
– Using S and B.
1
Au
0
The replicating portfolio for Au has the portfolio

weights
Auu Aud 1
u D D
Su Sd S.u d /
u dAuu uAud d
D D D :
.1 C r/.u d / .1 C r/.u d/

0
Ad
1
Similarly, the replicating portfolio for Ad has the

portfolio weights
u 1
D
S.u d/
u
Du D :
.1 C r/.u d/
But is it really worth it?

– We constructed Au and Ad ,
using S and B,
– so that we can replicate other security’s
payoffs using Au and Ad ,
instead of S and B.

It’s absolutely worth it!

To price assets using Au and Ad we don’t
need to know their replicating portfolios.
– We only need their prices!
What are their prices?
– Price their replicating portfolios:

Au D 1
S.u d /
S d
.1Cr/.u d /
1Cr d
D
.1 C r/.u d /
q
D
1Cr

Ad D 1
S.u d /
S u
.1Cr/.u d /
u .1 C r/
D
.1 C r/.u d /
1 q
D :
1Cr

That is, the prices of Au and Ad are the

discounted risk-neutral probabilities of the up
and down moves, respectively.
Now it should be obvious what the price of an
asset V is.
– Price the replicating portfolio.
If V pays Vu when the underlying goes up,
and pays Vd when it goes down, then
V D VuAu C Vd Ad

q 1 q
D Vu 1Cr C Vd 1Cr
qVu C .1 q/Vd
D :
1Cr
In practice we never worry about the replicating

portfolios for Au and Ad .
– Just their prices (undiscounted for time), and
these are easy to calculate.
They’re q and 1 q.

That is, on one level, risk neutral probabilities

are just a back-door way of constructing
replicating portfolios.
– Using particularly convienient portfolios of the
underlying and bonds.
But they have a concrete economic interpretation.

– The risk-neutral probability of the up-move is
closely related to the state price of the up
move.
Remember,
u q
A D :
1Cr
– That is, q=.1 C r/ is today’s price for a dollar

tomorrow that you only receive in the “state of
the world” that the stock price is high.
– And .1 q/=.1 C r/ is today’s price for a dollar
tomorrow that you only receive in the “state of
the world” that the stock price is low.
So what is q?

We can say a little more if we know p

The objective probability of the up move
Remember, the R-N probabilities price the stock:
q Su
S
1 q Sd
qSu C .1 q/Sd
S D
1Cr
“Altering” the probabilities was actually arbitrary

– It’s just a matter of interpretation
We could have “altered” the prices

– I.e., adjusted them for risk

The objective probabilities also price the stock

If we use risk-adjusted payoffs

q
p p
Su
S

1 q
1 p 1 p
Sd

q 1 q
p p
Su C .1 p/ 1 p
Sd
S D
1Cr
Remember, one interpretation of q:

– q=.1 C r/ D today’s price of the up dollar
Another interpretation of q:
– q=p D tomorrow’s value of a dollar in the up
state, relative to today’s value of a dollar
Typically think q < p, so q=p < 1
Stock goes up when the market goes up, so
you’re richer, value a marginal dollar less

(D) Two-Period Model
The tree for the stock:
uuS
uS
S udS
dS
ddS
The tree for the call:
cuu D .uuS K/C

cu
c cud D .udS K/C
cd
cd d D .ddS K/C

Dynamic Programming
I.e., start at the end, work backwards
From the one-period model:
q cuu C .1 q/ cud
cu D
1Cr
q cud C .1 q/ cd d
cd D :
1Cr
Once we know cu and cd , we have a one-period

model.
q cu C .1 q/ cd
c D
1Cr
q q cuuC.1
1Cr
q/ cud
C .1 q/ q cud C.1
1Cr
q/ cdd
D
1Cr
q 2cuu C 2q .1 q/cud C .1 q/2cd d
D :
.1 C r/2

That is, the call price is the discounted risk-neutral

expected payoff at maturity,
Q
E Œ ctC2
ct D
.1 C r/2
Q Q Q Q
P Œcuu cuu C P Œcud cud C P Œcdu cdu C P Œcdd cdd
D
.1 C r/2
where the risk-neutral probabilities for the final

payoffs are
Q
P Œ cuu D q 2
Q
P Œ cud D q .1 q/
Q
P Œ cdu D q .1 q/
Q
P Œ cd d D .1 q/2:
Note: the superscript-Q on the expectation or

probability operator denotes “under the risk-neutral
measure”
Just a fancy way of saying “use q instead of p”

Example: ABS’s stock is trading at $10 per share.

In each of the next two years the stock price will
either
– go up by 20%,
– or go down by 10%.
The simple annual risk-free rate is 10%.
What’s the price of a two-year ATM call?
First, draw the stock and option price-trees:

What are the option prices in one year?
So, what is today’s option price?

III. Dynamic Replication
Risk-neutral pricing is a powerful tool for pricing

options.
– Easy to implement, and fairly flexible.
– That’s why it’s used on the street.
However, the methodology obscures what’s really
underlying binomial option pricing.
– Binomial pricing works through NA replication of
an option’s payoff.
– Risk-neutral pricing works because it gives the
cost of replicating the option’s final payoff.
Also, if the payoff is path-dependent we need to
think about the whole tree
– I.e., if the option’s payoff depends on not just the
price of the underlying at maturity, but also on
how it got there, we can’t dispense with the tree.
We showed how to replicate a call on a one-period

tree. Now, we’ll show how to dynamically replicate a
call option in a multi-period binomial model.

Example continued ...
Consider our two-period example again. In the

example
u D 1:2
d D 0:9
r D 0:1
.1 C 0:1/ 0:9 2
) q D D
1:2 0:9 3
The stock price tree was
14:40
12
10 10:80
9
8:10

The call price tree is
4:40
cu
c 0:80
cd
0
Risk-neutral calculations give
2
3
4:40 C 13 0:80
cu D D 2:91
1:1
2
3
0:80 C 13 0
cd D D 0:48
1:1
2
3
2:91 C 13 0:48
) c D D 1:91:
1:1

So the call price on the tree evolves like
4:40
2:91
1:91 0:80
0:48
0
Question: how does the replicating portfolio evolve

over time?

At the u -node (time 1 )

The replicating portfolio for a call has u shares of
stock and Du dollars of borrowing:
cuu cud
u D
uuS udS
4:4 0:8
D D 1
14:4 10:8
dcuu ucud
Du D
.1 C r/.u d /
0:9 4:4 1:2 0:80
D D 9:09:
1:1 .1:2 0:9/
Check that one share of stock and $9:09 of

borrowing replicates the option payoff at time 2:
1:2 12 1:1 9:09 D 4:4

0:9 12 1:1 9:09 D 0:8:
The cost of the u-node replicating portfolio is
1 12 9:09 D 2:91:

At the d -node (time 1 )

The replicating portfolio for a call has d shares of
stock and Dd dollars of borrowing:
cud cd d
d D
udS ddS
0:8 0
D D 0:296
10:8 8:10
dcud ucd d
Dd D
.1 C r/.u d /
0:9 0:80 1:2 0
D D 2:18:
1:1 .1:2 0:9/
Check that 0:296 shares of stock and $2:18 of

borrowing replicates the option payoff at time 2:
1:2 .0:296 9/ 1:1 2:18 D 0:8

0:9 .0:296 9/ 1:1 2:18 D 0:
The cost of the d -node replicating portfolio is
0:296 9 2:18 D 0:48:

At time 0
The replicating portfolio should satisfy
cu cd
0 D
uS dS
2:91 0:48
D D 0:808
12 9
dcu ucd
D0 D
.1 C r/.u d /
0:9 2:91 1:2 0:48
D D 6:17:
1:1 .1:2 0:9/
Check that 0:81 shares of stock and $6:17 of

borrowing replicates the option payoff at time-1:
1:2 .0:808 10/ 1:1 6:17 D 2:91

0:9 .0:808 10/ 1:1 6:17 D 0:48:
The cost of the time-0 replicating portfolio is
0:808 10 6:17 D 1:91:

The replicating portfolio develops dynamically over

time
D 1
D D $9:09
D 0:808
D D $6:17
D 0:296
D D $2:18
That’s we call it dynamic replication.
We cannot replicate the payoff of the option at

maturity using a buy-and-hold strategy.
– That is, we can’t use static replication, like we
did for forwards.
To replicate the payoff of an option we have to
rebalance the replicating portfolio every period.
– “every period” really = every price change.
– Note: the strategy is also self-financing.
Note that calls are a “strategy” that “doubles up”

– when the stock goes up you “buy” more
– when the stock goes down you “sell” some

How do we arbitrage an option mispricing?
Suppose that the ATM call was priced at $2.

At time-0
– Write the call
It’s over priced.
– Construct the replicating portfolio. Cost: $1:91.
– Put the $0:09 in the bank (i.e., buy bonds).
At time-1, rebalance the replicating portfolio.
– If the stock went up, buy more stock
– If the stock went down, sell some stock
At time-2, you have to payoff on the call you’re
short.
– But liquidating the replicating portfolio exactly
covers this liability.
You’re up the $0:09 mispricing, plus interest.
What would you do if the call were selling for $1:85?

Another example: the ATM put
0
pu
p 0
pd
1:90
Clearly pu D 0. Risk-neutral calculations give
2
3
0 C 13 1:90
pd D D 0:58
1:1
2
3
0 C 13 0:58
) p D D 0:17:
1:1
0
0
0:17 0
0:58
1:90

The replicating portfolio at the d -node:
pdu pd d
d D
Sdu Sd d
0 1:90
D D 0:704
10:80 8:10
dpdu upd d
Dd D
.1 C r/.u d /
0 1:2 1:90
D D 6:91
1:1 0:3
Note: 0:704 9 C 6:91 D 0:58.
At the time-0:
pu pd 0 0:58
0 D D D 0:192
Su Sd 12 9
dpu upd 0 1:2 0:58
D0 D D D 2:09
.1 C r/.u d / 1:1 0:3
And 0:192 10 C 2:09 D 0:17.

Again, the replicating portfolio develops dynamically

over time
D 0
D D 0
D 0:192
D D $2:09
D 0:704
D D $6:91
Note that puts are also a “strategy” that “doubles

up”
– when the stock goes down you short “more”
that is, if things go your way you increase your
position
– when the stock goes up you buy some back
if things go against you, you decrease your
position

Also, put-call parity holds in our examples.
Put-call parity says
cK pK D S K B:
The replicating portfolio for the portfolio of options is
D 1 0 D1
DD9:09 0D9:09
D 0:808 . 0:192/ D 1
DD6:17 . 2:09/D8:26
D0:296 . 0:704/D1
DD2:18 . 6:91/D9:09
Payoff tree for synthetic forward, made either way:
4:40 0D4:40
14:40 10
2:91 0D2:91
12 9:09
1:91 0:17D1:74 0:80 0D0:80
10 8:26 10:80 10
0:48 0:58D 0:09
9 9:09
0 1:90D 1:90
8:10 10

IV. Multi-Period Models

A. Three-Period Model
uuuS
uuS
uS uudS
S udS
dS uddS
ddS
dddS
1
3 2
c D 3
q c uuu C 3q .1 q/ cuud
.1 C r/

C 3q .1 q/2 cud d C .1 q/3 cd d d
We could keep going; gets tedious very quickly.

We need a general solution
– For counting the number of paths to each payoff
at maturity.
– The method needs to account for each path’s
“probability.”

B. The General n-Period Model
let
n D number of steps,
j D number of up-moves to n;
) n j D number of down-moves to n:
Then the number of paths that lead to cuj d n j is
nŠ
where nŠ D n .n 1/ .n 2/ 2 1
j Š.n j /Š
So, the option price in an n-period model is:

n
1 X nŠ j
c D n
q .1 q/n j cuj d n j
.1 C r/ j D0 j Š.n j /Š
where C
j n j
c uj d n j D u d S K
and 1 C r is the simple one period discount rate.

Let a denote the fewest number of up-moves the

stock needs to make for the call to finish in the money.
I.e., pick a such that
S ua 1
d .n aC1/
K
S u a d .n a/
K:
Then, the price of the call can be written
n
1 X
j
c D nŠ
q .1 q/n j Œuj d n j S K
.1 C r/n j Da j Š.n j /Š
"
n
1 X
j
D n
nŠ
j Š.n j /Š
q .1 q/n j uj d n j S
.1 C r/ j Da
n
#
X
nŠ
j Š.n j /Š
q j .1 q/n j K :
j Da

Can write this as two terms:
0 1
n
uj d n j
X
nŠ j n j
c D @ j Š.n j /Š
q .1 q/ .1Cr/n
AS
j Da
0 1
n
X
nŠ

j n jA K
@
j Š.n j /Š
q .1 q/ :
j Da
.1 C r/n
Some interpretation: 1=.1 C r/n D Bt;T
So the equation describes a replicating portfolio

– Long the stock: # of shares
n
uj d n j
X
nŠ j n j
j Š.n j /Š
q .1 q/ .1Cr/n
j Da
– Short bonds with a face = K: # of bonds

n
X
nŠ
j Š.n j /Š
q j .1 q/n j
j Da

We can also interpret these positions:

Pn
nŠ
Bond position, j Da q j .1 q/n j is the
j Š.n j /Š
“probability” that the call finishes in-the-money.
The probability “under the risk-neutral measure”,
n
X Q
nŠ
j Š.n j /Š
q j .1 q/n j
D Pt ŒST > K:
j Da
Stock position,
n
uj d n j
X
nŠ
j Š.n j /Š
q j .1 q/n j
.1Cr/n
j Da
Q Q
h ˇ i
ST =St ˇ
D Pt ŒST > K Et S
.1Cr/n ˇ T
>K ;
The probability of exercise, times the discounted

growth in the stock price in the “good” states of the
world

So the price of the call is

0 1
n
uj d n j
X
j
ct D @ nŠ
j Š.n j /Š
q .1 q/n j
.1Cr/n
A St
j Da
0 1
Xn
nŠ
@
j Š.n j /Š
q j .1 q/n j A KBt;T
j Da
Q
h i Q
ST =St
D Et .1Cr/n
1ST >K St Pt ŒST > K KBt;T
This looks a lot like Black-Scholes!

The Black-Scholes value of a call:
rT
c D N.d1/ S N.d2 / Ke
We can get to Black-Scholes by letting n ! 1

– and doing a lot of algebra
We’ll get there a different way

How many steps do we need?

Binomial option prices.
– As a function of number of periods used in the
calculation.
– Holding all other variables, including time-to-
maturity, constant (i.e., as n ", t #).

5 Binomial Trees

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Lecture 6:

Binomial Option Pricing Model

This lecture shows that if stock prices move in a

Binomial Option Pricing

 The option pricing methodology used most on the

 Developed by Cox, Ross and Rubinstein.

 More flexible than Black-Scholes pricing,

B35100 Page 2 Robert Novy-Marx

We’ve used replicating portfolios in class already.

 How did we price a forward contract?

 We’d like to do the same thing with options.

B35100 Page 3 Robert Novy-Marx

We make a seemingly ridiculous simplification:

 We’re going to assume than in the future the stock

B35100 Page 4 Robert Novy-Marx

At the end of this period, a ATM call option (K D $60)

Now let’s look at a portfolio

 It replicates the call’s payoffs.

B35100 Page 5 Robert Novy-Marx

The price of the portfolio is initially

The portfolio replicates the payoff of the call option,

 What if the price of the call is $18:50?

Transaction Payoff at t Payoff at T

 What if the price of the call is $16:50?

Transaction Payoff at t Payoff at T

B35100 Page 6 Robert Novy-Marx

How do we “guess” the replicating portfolio?

In the previous example we “guessed”  D 0:5 and

B35100 Page 7 Robert Novy-Marx

Again, the delta of an option is the sensitivity of the

We know that  will always be between 0 and 1.

 Remember: in our numeric example,

C0 D 0:5 S0 12:5 D 17:50:

 Why is it always be between 0 and 1?

Can we see this graphically?

B35100 Page 8 Robert Novy-Marx

The sensitivity of the call to the underlying:

There should also be a short bond position.

 The y-intercept isn’t zero.

B35100 Page 9 Robert Novy-Marx

Why this works

Because there’s a linear relation between the price

B35100 Page 10 Robert Novy-Marx

Where do we use the probabilities of the up and down

Important: The option price we got did not depend

We don’t need the probabilities of the price moves to

Question: why doesn’t the option price depend on

B35100 Page 11 Robert Novy-Marx

 If we priced options by discounting future payoffs,

 But we don’t. We price options as a function of the

Does this mean that news which leads to an increase

B35100 Page 12 Robert Novy-Marx

II. Binomial Option Pricing Model

We’ll argue (in lecture 7) that it’s reasonable to

B35100 Page 13 Robert Novy-Marx

(B) One-Period Model

The payoffs of the stock are:

To prevent arbitrage we’ll also require that

where r is the risk-free borrowing/lending rate.

B35100 Page 14 Robert Novy-Marx

The payoffs of a call option (at maturity) are:

where X C  maxŒX; 0:

The payoffs of a portfolio with  shares of the stock

The option pricing methodology used most on the

Developed by Cox, Ross and Rubinstein.

More flexible than Black-Scholes pricing,

How did we price a forward contract?

We’d like to do the same thing with options.

We’re going to assume than in the future the stock

It replicates the call’s payoffs.

What if the price of the call is $18:50?

What if the price of the call is $16:50?

In the previous example we “guessed” D 0:5 and

We know that will always be between 0 and 1.

Remember: in our numeric example,

Why is it always be between 0 and 1?

The y-intercept isn’t zero.

If we priced options by discounting future payoffs,

But we don’t. We price options as a function of the

where X C maxŒX; 0:

The payoffs of a portfolio with shares of the stock

Then uS .1 C r/D D pu )

Just like for the call, only now 0 and D 0.

How much Intel is it long?

How big is the debt position?

Substituting for and D gives the call price as

There was nothing special about the call.

Now do some algebra

Finally, if we define, as an algebraic convenience,

What does this “say”?

That is, the call’s price is just the discounted

We call q the risk-neutral probability of the

We call the true probability, p, the objective

Why do we call q the risk-neutral probability?

It’s easier than calculating, and then pricing,

For a minute, let’s forget entirely about the

Let’s hypothesize a fictional world.

Question: what is the price of a call in this

No-arbitrage considerations imply the relation

By assumption, S, u, d and r are exactly the

No-arbitrage relationships are independent of

We could replicate the payoffs by constructing

Pricing options in this fictitious, risk-neutral

Asset price are discounted, expected payoffs:

But what is q, the probability the stock price

quS C .1 q/dS D Et ŒStC1 D .1 C r/S:

Once we have the risk-neutral probabilities, it’s

That is, in the risk-neutral world, given any

So, in the risk-neutral world

But what does this tells us about c in the “real

It tells us exactly the price of the call in the “real

Remember, we assumed prices in this risk-