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Chapter 12
1 C. Hull 2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John2C. Hull
2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John3C. Hull
2013
22 1
Down
Move
18
is riskless when
22 1
= 18 or = 0.25
Portfolio
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John4C. Hull
2013
portfolio that is
long 0.25 shares
short 1
option
is worth 4.367
The value of the shares is
5.000 (= 0.25 20 )
The value of the option is therefore
0.633 (= 5.000 4.367 )
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John6C. Hull
2013
Up
Move
Su
u
Down
Move
Sd
d
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John7C. Hull
2013
Generalization (continued)
S0u u
Down
Move
S0d d
The portfolio is riskless when S0u u = S0d d or
u f d
S 0u S 0 d
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John8C. Hull
2013
Generalization
(continued)
Value
Value
Another
Generalization
(continued)
e rT d
p
ud
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John10
C. Hull
2013
p as a Probability
S0
S0u
u
S0d
d
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John11
C. Hull
2013
Risk-Neutral Valuation
When the probability of an up and down
movements are p and 1-p the expected stock
price at time T is S0erT
This shows that the stock price earns the riskfree rate
Binomial trees illustrate the general result that to
value a derivative we can assume that the
expected return on the underlying asset is the
risk-free rate and discount at the risk-free rate
This is known as using risk-neutral valuation
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John12
C. Hull
2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John13
C. Hull
2013
(1
p)
Su = 22
u = 1
Sd = 18
d = 0
0.12
Since p isearT risk-neutral
probability
20e
0.120.25
d e
0.9
0.25
p
0.6523
= 22p +u18(1
p
);
p
=
0.6523
d
1.1 0.9
Alternatively, we can use the formula
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John14
C. Hull
2013
3
2
5
6
0.
Su = 22
u = 1
0.34
77
Sd = 18
The value of the option is d = 0
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John15
C. Hull
2013
A Two-Step Example
Figure 12.3, page 280
24.2
22
20
19.8
Each
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John16
C. Hull
2013
22
20
1.2823
2.0257
18
24.2
3.2
19.8
0.0
0.0
Value at node B
= e0.12
16.2
0.25
F
(0.65233.2 + 0.34770) = 2.0257
0.0
Value at node A
= e0.12
0.25
(0.65232.0257 + 0.34770)
= 1.2823
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John17
C. Hull
2013
50
4.1923
60
1.4147
40
9.4636
72
0
48
4
32
20
60
50
5.0894
The American feature
increases the value at node
C from 9.4636 to 12.0000.
48
4
1.4147
40
12.0
32
20
Delta
Delta
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John20
C. Hull
2013
Choosing u and d
One way of matching the volatility is to set
u e
d 1 u e
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John22
C. Hull
2013
ad
ud
ae f
for a currency where r f is the foreign
risk - free rate
a 1 for a futures contract
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John23
C. Hull
2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John24
C. Hull
2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John25
C. Hull
2013