FINANCIAL MATHEMATICS III

MATH3803
Multi-Period Binomial Trees

𝒑∗ 𝒖𝒖𝑺
𝒑∗ 𝒖𝑺
𝑺 𝒑∗ 𝒖𝒅𝑺
𝒅𝑺
𝒅𝒅𝑺
Multi-Period Binomial Trees
Multi-period binomial trees can be used to value
American options, which may be exercised prior to
the expiration date of the option.
To value an American option you look at the expected
present value of exercising at a later date, and
compare it with the value of exercising the option
early.
If it’s more valuable to exercise early you treat the
value at that node as the value if exercised.
Multi-Period Binomial Trees

𝒑∗ 𝟕𝟐
∗ 𝟔𝟎 𝒖 = 𝟏. 𝟐
𝒑
𝒅 = 𝟎. 𝟖
𝟓𝟎 𝒑∗ 𝟒𝟖 𝒓 = 𝟓%
𝟒𝟎 𝒑∗ = 𝟎. 𝟔𝟐𝟖𝟏𝟖
𝟑𝟐
Multi-Period Binomial Trees
𝒑∗ 𝒄𝒖𝒖
𝒑∗ 𝒄𝒖
𝒄 𝒑∗ 𝒄𝒖𝒅
𝒄𝒅
𝒄𝒅𝒅

For a European option the values of the option at the

exercise date (𝒄𝒖𝒖 , 𝒄𝒖𝒅 and 𝒄𝒅𝒅 ) are the payoffs if the
stock takes values 𝑺𝒖𝒖 , 𝑺𝒖𝒅 and 𝑺𝒅𝒅 .
Multi-Period Binomial Trees
𝟕𝟐 𝟏𝟕
𝟔𝟎 𝒄𝒖
𝟓𝟎 𝟒𝟖 𝒄 𝟎
𝟒𝟎 𝒄𝒅
𝟑𝟐 𝟎

So to value a European call option on this stock, with

strike price 55 and exercise at the end of the second
period, we first calculate the payoffs at the exercise
date = 𝑴𝒂𝒙[𝟎, 𝒔𝒕𝒐𝒄𝒌 𝒑𝒓𝒊𝒄𝒆 − 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆]
Multi-Period Binomial Trees
𝟕𝟐 𝟏𝟕
𝟔𝟎 𝒄𝒖
𝟓𝟎 𝟒𝟖 𝒄 𝟎
𝟒𝟎 𝒄𝒅
𝟑𝟐 𝟎
The values 𝒄𝒖 and 𝒄𝒅 are the expected present values
of their payoffs at the end of the second period:
𝒄𝒖 = 𝒄𝒖𝒖 𝒑∗ + 𝒄𝒖𝒅 𝟏 − 𝒑∗ 𝒆−𝒓 = 𝟏𝟕𝒑∗ 𝒆−𝒓 + 𝟎 = 𝟏𝟎. 𝟏𝟔
𝒄𝒅 = 𝒄𝒖𝒅 𝒑∗ + 𝒄𝒅𝒅 𝟏 − 𝒑∗ 𝒆−𝒓 = 𝟎 + 𝟎
Multi-Period Binomial Trees
𝟕𝟐 𝟏𝟕
𝟔𝟎 𝟏𝟎. 𝟏𝟔

𝟓𝟎 𝟒𝟖 𝒄 𝟎
𝟒𝟎 𝟎
𝟑𝟐 𝟎
The European call premium is equal to the expected present
value of the call values payoffs at the end of the first period:
𝒄 = 𝒄𝒖 𝒑∗ + 𝒄𝒅 𝟏 − 𝒑∗ 𝒆−𝒓
𝒄 = 𝟏𝟎. 𝟏𝟔𝒑∗ 𝒆−𝒓 = 𝟔. 𝟎𝟕