21 - The Binomial Model

21.
The Binomial Model

21.1 Continuous-Compounding
Suppose that you invest $1 at rate r = 10%. How much do you have at
the end of one year?
21-2
the end of one year? It depends on the compounding interval:
Compounding Interval n (1+r/n )n

Annual 1 1.1 After one year, the
Semi-Annual 2 1.1025 interest is $0.10.
Quarterly 4 1.10381
Monthly 12 1.10471
Weekly 52 1.10506
Continuous infinity 1.10517
21-3
Compounding Interval n (1+r/n )n • After six months you

Annual 1 1.1 have $1.05.
Semi-Annual 2 1.1025 • You then reinvest
$1.05 and get $1.1025
Quarterly 4 1.10381 after one year.
Monthly 12 1.10471 • The interest is now
Weekly 52 1.10506 $0.1025 (more than
Continuous infinity 1.10517 $0.10 since there is
interest on interest).
21-4
Compounding Interval n (1+r/n )n • Continuous-

Annual 1 1.1 compounding can be
Semi-Annual 2 1.1025 thought of as
instantaneous
Quarterly 4 1.10381 compounding
Monthly 12 1.10471 (compounding instant
Weekly 52 1.10506 by instant).
Continuous infinity 1.10517 • The interest is now
$0.10517 (more
interest on interest).
21-5
Compounding Interval n (1+r/n )n

Annual 1 1.1
Semi-Annual 2 1.1025
Quarterly 4 1.10381
Monthly 12 1.10471
Weekly 52 1.10506
Continuous infinity 1.10517
• As n goes to infinity, (1+r/n)n approaches er (e ≈ 2.718281828).
• Hence, an investment of $1 grows to e0.1 = $1.10517.
• Importantly, the derivation of the Black-Scholes formula needs continuous-
compounding (intuition will be provided later).
21-6
• If you invest K at risk-free rate r with continuous-compounding, then at
the end of T years you have:
K × erT.
Example
Suppose that you invest $1,000 at the continuously compounded risk-
free rate r = 5%. How much do you have at the end of three months?
After three months, you have:
$1,000  e0.05(3/12) = $1,012.58.
With simple compounding, you have a bit less:

$1,000 × [1 + 0.05 × (3/12)] = $1,000 × (1 + 0.0125) = $1,012.50.
• For discounting, use e–rT.

21-7
21.2 Single-Period Binomial Option Pricing Model
• In the Binomial Option Pricing Model (BOPM), there are three
securities:
1. Stock;
2. Risk-free zero-coupon bond with a face value of $1;
3. European call option on the stock.
• The model’s main goal is to find the current value of the call
option given the current stock and bond prices;
• Key assumptions:
– There are two states of nature (i.e., the stock can go either up or down); and
– The Law of One Price holds (i.e., two portfolios with the same future payoffs
have the same price today).
21-8
• A very simple example:
Stock Bond Call option (E =1)
2 1
Ps = 1.5
Pb = 0.9
Pc = ? 1 1
21-9
2 1 1
Ps = 1.5
Pb = 0.9
Pc = ? 1 1 0
21-10
2 − 1 = 1
Ps = 1.5
Pb = 0.9
Pc = ? 1 − 1 = 0
21-11
2 − 1 = 1
Ps = 1.5
Pb = 0.9
Pc = ? 1 − 1 = 0
In terms of payoffs, we have:

stock – bond = call option
That is, a portfolio that involves a long position in one share of the stock and a short
position in one bond has the same payoffs as (i.e., “replicates”) the call option.
21-12
2 − 1 = 1
Ps = 1.5
Pb = 0.9
Pc = 0.6 1 − 1 = 0
In terms of payoffs, we have:

stock – bond = call option
That is, a portfolio that involves a long position in one share of the stock and a short
position in one bond has the same payoffs as (i.e., “replicates”) the call option.
Using the Law of One Price, we have a similar relation for prices:
Ps – Pb = Pc
1.5 – 0.9 = 0.6
21-13
• More generally, the binomial tree is:
Stock Bond Call option
Su 1 Cu
Ps
Pb
Pc = ? Sd 1 Cd
• The question is: given Ps and Pb, what is Pc?
21-14
• Let Ns and Nb denote the numbers of, respectively, shares and
bonds in the portfolio that replicates the option;
• We need to solve two equations with two unknowns (Ns and
Nb) to replicate the call option with the stock and bond:
Ns  Su + Nb = Cu
Ns  Sd + Nb = Cd
• Subtracting the second equation from the first equation:
Ns  (Su – Sd ) = Cu – Cd .
• It follows that:
Ns = (Cu – Cd )/(Su – Sd ).
21-15
• After some algebra, we have:
Nb = (Cd  Su–Cu  Sd )/(Su – Sd).
• Recall that a portfolio of Ns shares and Nb bonds replicates
the call option.
• Assuming that the Law of One Price holds, the value of the
call option is the sum of:
(1) The current price of Ns shares; and
(2) The current price of Nb bonds.
• Hence:
Pc = Ns  Ps + Nb  e–rT
(with continuous-time discounting, Pb = PV(1) = e–rT since the zero-coupon
bond has a face value of $1 and matures at time T).
21-16
Example
A given stock closed at $71.25. Five months from now the stock price
will be either $100 or $60. Find the current value of a five-month
European call option on the stock with an exercise price of $80. Assume
that the continuously compounded risk-free rate is 5%.
21-17
Example
Stock Bond Call Option
100 1 Cu = max (0,100–80) = 20
Ps=71.25
60 1 Cd = max (0,60–80) = 0
21-18
Example
100 1 Cu = max (0,100–80) = 20
Ps=71.25
60 1 Cd = max (0,60–80) = 0
Ns = (Cu–Cd)/(Su–Sd )
= (20 – 0)/(100 – 60)
= 0.5.
21-19
Example
100 1 Cu = max (0,100–80) = 20
Ps=71.25
60 1 Cd = max (0,60–80) = 0
Ns = (Cu–Cd)/(Su–Sd ) Nb = (CdSu–CuSd)/(Su–Sd)
= (20 – 0)/(100 – 60) = (0100–2060)/(100–60)
= 0.5. = –30.
21-20
Example
100 1 Cu = max (0,100–80) = 20
Ps=71.25
60 1 Cd = max (0,60–80) = 0
Ns = (Cu–Cd)/(Su–Sd ) Nb = (CdSu–CuSd)/(Su–Sd)
= (20 – 0)/(100 – 60) = (0100–2060)/(100–60)
= 0.5. = –30.
Pc = NsPs+Nb e–rT.
= 0.571.25–30e–0.05(5/12)
= $6.24.
21-21
Suppose that the stock price goes up $1 (i.e., ΔPs=$1). What is the
change in the call option price, ΔPc? Recall that Ns = 0.5.
? $1
Pc = NsPs+Nb e–rT
21-22
? $1
Since Ns = 0.5, we have ΔPc = $0.50.
Intuitively, the call option can be thought of as a portfolio that involves

Ns = 0.5 shares (and Nb = -30 bonds).
If the stock price goes up $1, then the price of the portfolio (and the
value of the call option) goes up $0.50.
Also, Ns is called the hedge ratio (in this example, we need 0.5 shares to
hedge the call option).
21-23
? $1
Since Ns = 0.5, we have ΔPc = $0.50.
Intuitively, the call option can be thought of as a portfolio that involves

Ns = 0.5 shares (and Nb = -30 bonds).
If the stock price goes up $1, then the price of the portfolio (and the
value of the call option) goes up $0.50.
The percentage change in the stock price is 1.4% [= $1/$71.25].

The percentage change in the call option price is 8% [= $0.5/$6.24].
21-24
21.3 Put-Call Parity
• Strategy I:
– Long European put option on a stock with exercise price E; and
– Long stock.
• Strategy II:
– Long European call option on a stock with exercise price E; and
– Long zero-coupon bond with face value E.
21-25
21.3 Put-Call Parity
• Strategy I:
– Long European put option on a stock with exercise price E; and
– Long stock.
• Strategy II:
– Long European call option on a stock with exercise price E; and
– Long zero-coupon bond with face value E.
PT  E PT > E
Long Put E - PT 0
Long Stock PT PT
Total Strategy I E PT
Long Call 0 PT - E
Long Bond E E
Total Strategy II E PT
Strategies Strategies
I and II I and II
have the have the
same future same future
payoffs if payoffs if
PT ≤ E PT > E
• That is, in terms of payoffs:
Put + Stock = Call + Bond.
• If the Law of One Price holds, then we have a similar
relation for prices:
Pp + Ps = Pc + Pb.
• This relation is known as put-call parity.
• Put-call parity is useful to find the price of a European put
option given the prices of an otherwise identical European call
option, bond, and stock:
Pp = Pc + Pb − Ps.
21-27
Example
Recall that: (1) the value of a five-month European call option with an exercise
price of $80 is $6.24; (2) the stock price is $71.25; and (3) the continuously
compounded risk-free rate is 5%. Find the value of a five-month European put
option with an exercise price of $80.
Using put-call parity:

Pp = P c + P b – Ps
= 6.24+80e–0.05(5/12) –71.25
= $13.34.
Recall that the zero-coupon bond used in put-call parity: (a) has a face value
equal to the exercise price of the option; and (b) matures at time T. Hence:
Pb = PV($80) = 80e–0.05(5/12) .
In sum: given the value of a European call option, it is straightforward to find

the value of an otherwise identical European put option by using put-call parity.
21-28
The Hedge Ratio of a Put Option
• Put-call parity says that:
Pp + Ps = Pc + Pb.
• Suppose that the stock price increases $1.
• It follows from put-call parity that:
Pp + Ps = Pc + Pb.
N Sput1  N Scall0
or
N Sput N Scall 1
• Suppose that the hedge ratio of a call option is 0.6.
• Then, the hedge ratio of an otherwise identical put option is –0.4 [= 0.6 – 1].
• If the stock price increases $1, then the put option price decreases $0.40.
21-29
21.4 Two-Period Binomial Option Pricing Model
• The single-period BOPM is restrictive: the stock can only take two values on
the option’s expiration date;
• However, the BOPM can be extended to allow any number of periods;
• In the two-period BOPM, we have:
Suu
Su
Ps Sud= Sdu
Sd
Sdd
• In the two-period BOPM, the stock can take three values on the option’s
expiration date (more realistic than in the single-period BOPM).
21-30
• How should we value a call option in the two-period BOPM?
• We apply the reasoning used in the single-period BOPM by

working backwards.
• Hence, the problem is divided into three parts…
21-31
First, we find the value of the option at the intermediate date
when the stock price is Su.
Suu
Su
Ps Sud= Sdu
Sd
Sdd
21-32
Second, we find the value of the option at the intermediate
date when the stock price is Sd.
Suu
Su
Ps Sud= Sdu
Sd
Sdd
21-33
Third, we find the value of the option at the initial date given
the values of the call option at the intermediate date (the latter
values are determined in the first and second parts).
Suu
Su
Ps Sud= Sdu
Sd
Sdd
21-34
Example
A given stock closed at $71.25. You forecasted that:
– 2.5 months from now the stock price will be either $90 or $60.
– If the stock price rises to $90, then the price 2.5 months later will be
either $100 or $85.
– If the stock price falls to $60, then the price 2.5 months later will be
either $85 or $40.
Using the two-period BOPM, find the current value of a five-month

European call option on the stock with an exercise price of $80.
The continuously compounded risk-free rate is 5%.
21-35
The two-period binomial tree for the stock price is:
call
stock option
100 20
90
71.25 85 5
60
40 0
21-36
First, we find the value of the option on the intermediate date
when the stock price is 90:
Nsu = (Cuu – Cud )/(Suu – Sud )
= (20 – 5)/(100 – 85)
= 1.
Nbu = (CudSuu – Cuu  Sud )/(Suu – Sud).
= (5100 – 2085)/(100 – 85)
= –80.
At the intermediate date, the option expires in 2.5 months (i.e.,
T = 2.5/12). Hence:
Pcu = NsuPsu+Nbu e–rT.
= 190–80e–0.05(2.5/12)
= $10.83.
21-37
Second, we find the value of the option on the intermediate
date when the stock price is 60:
Nsd = (Cdu–Cdd )/(Sdu–Sdd )
= (5 – 0)/(85 – 40)
= 0.1111,
Nbd = (CddSdu–CduSdd )/(Sdu–Sdd).
= (085–540)/(85–40)
= –4.4444,
and
Pcd = NsdPsd+Nbd e–rT.
= 0.111160–4.4444e–0.05(2.5/12)
= $2.27.
21-38
The single-period binomial tree resulting from the first two
parts is:
stock bond call option
90 1 10.83
71.25
60 1 2.27
21-39
Third, we find the value of the option on the initial date:
Ns = (Cu–Cd )/(Su–Sd )
= (10.83 – 2.27)/(90 – 60)
= 0.2853,
Nb = (CdSu–CuSd )/(Su–Sd).
= (2.2790–10.8360)/(90–60)
= –14.85,
and
Pc = NsPs+Nb e–rT.
= 0.285371.25–14.85e–0.05(2.5/12)
= $5.63.
21-40

21 - The Binomial Model

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21.

The Binomial Model

Compounding Interval n (1+r/n )n

Compounding Interval n (1+r/n )n • After six months you

Compounding Interval n (1+r/n )n • Continuous-

Compounding Interval n (1+r/n )n

After three months, you have:

$1,000  e0.05(3/12) = $1,012.58.

With simple compounding, you have a bit less:

• For discounting, use e–rT.

In terms of payoffs, we have:

In terms of payoffs, we have:

Stock Bond Call option

• The question is: given Ps and Pb, what is Pc?

Since Ns = 0.5, we have ΔPc = $0.50.

Intuitively, the call option can be thought of as a portfolio that involves

Since Ns = 0.5, we have ΔPc = $0.50.

Intuitively, the call option can be thought of as a portfolio that involves

The percentage change in the stock price is 1.4% [= $1/$71.25].

Using put-call parity:

In sum: given the value of a European call option, it is straightforward to find

• We apply the reasoning used in the single-period BOPM by

• Hence, the problem is divided into three parts…

Using the two-period BOPM, find the current value of a five-month

stock bond call option

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