The Binomial Model for Pricing Options

T he binomial model for option pricing is based upon a special case in which the price of a stock over some period can either go up by u percent or down by d percent. If S is the cur rent price then next period the price will be either Su =S(1+u) or Sd =S(1+d). If a call option is held on the stock at an exercise price of E then the payoff on the call is either C u =max(Su-E ,0) or C d =max(Sd-E ,0). L et the risk-free interest be r and assume d<r<u. Now consider a portfolis made up of one written call and h shares of the stock. T hat is to say, the owner of the portfolio owns h shares of the stock and then sells(writes) one call with an expiration date of one period. If the stock price goes up the portfolio has a value of V u = hS(1+u) - C u and if it goes down V d = hS(1+d) - C d . Suppose h is chosen so that the portfolio has the same price whether the stock price goes up or goes down. T he value of h that achieves this condition is given by hS(1+u) - C u = hS(1+d) - C d or h = (C u-C d)/(Su-Sd) = (max(Su-E ,0)-max(Sd-E ,0))/(Su-Sd). Thus, given only S,E,u,and d, the ratio h can be determined. In particular, it does not depend upon the probability of a rise or fall. The value of h that make the value of the portfolio independent of the stock price is called the hedge ratio. A portfolio that is perfectly hedged is a risk-free portfolio so its value should grow at the riskfree rate; i.e., r. The current value of the hedged portfolio is the value of the stocks less the liability involved with having written the call. If C represents the value of owning the call then the liability involve with having written the call is -C. Therefore the value of the portfolio is (hS-C). After one period of growing at the risk-free rate its value will be (1+r)(hS-C), which is the same as (hS(1+u)Cu)=(hS(1+d)-Cd). Solving for C gives

C = hS - (hS(1+u)-C u)/(1+r) = hS - hS(1+u)/(1+r) + C u/(1+r) = hS[1 -(1+u)/(1+r)] + C u/(1+r) = (hS(r-u) + C u)/(1+r) = [-hS(u-r) + C u]/(1+r) Noting that h = (C u-C d)/(S(1+u)-S(1+d)) = (C u-C d)/S(u-d) then C = [(C u-C d)(r-u)/(u-d) + C u]/(1+r) = [C u[(r-u)/(u-d) + 1] -C d(r-u)/(u-d)]/(1+r) C = [C u(r-d)/(u-d) + C d(u-r)/(u-d)]/(1+r) If (r-d)/(u-d) is denoted as p then 1-p = [(u-d)-(r-d)]/(u-d) = (u-r)/(u-d) so C = [p C u + (1-p)C d]/(1+ r) T hus the value of the call option is the discounted value of a weighted average of the expiration date value of the call. E xample: Let u=+0.1, d=-0.1, r= 0.05, S = 100, and E = 95. Then Su=110 and Sd=90 and consequently Cu = 15 and Cd = 0. Therefore, h=(15-0)/(110-90)=0.75 p = (0.05 - (-0.1))/(0.1 - (-0.1)) = 0.15/0.20 = C = [(3/4)15 +(1/4)0]/(1.05) = 11.5/1.05 = $10.71. L et us check this out by computing the value of the portfolio. 0.75 share of the $100 stock - $10.71 = $75.00 - $10.71 = $64.29. If the price of the stock rises to $110 then the portfolio will be worth (.75)(110) - 15 = 82.50 - 15.00 = $67.50. If the price of the stock drops to $90 the portfolio will be worth (.75)(90) = $67.50. T he one-period result may be used to determine the value of a call with two periods left before expiration. T he two period results then gives the three period result and so on. T he results look the same as if one were computing the expected value of the expiration date payoff when the probability of stock price going up in one period is p and the probability of going down is (1-p).

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Q uestion 1 (Binomial Model)

OPM Questions

Silverlake s current stock price is $60 per share. Call options for this stock exist that permit the holder to purchase one share at an exercise price of $50. These options will expire at the end of 1 year, at which time Silverlake s stock will be selling at bone of two prices, $45 or $70. The risk-free rate is 7%. As an assistant to the firm s treasurer, you have been asked to perform the following tasks to arrive at the value of the firm s call options. a. b. c. d. Create a riskless hedged investment What is the cost of the sock in the riskless portfolio? What is the present value of the riskless portfolio? What is the value of the firm s call option?

Q uestion 2 (Binomial Model) Given the following information, create a riskless hedge to determine the value of the firm s call option. What is the value of the firm s call option? Current stock price = $25 Exercise price = $30 Option expiration = 6 months Risk-free rate = 5% At the end of 6 months, the firm s stock will be worth $20 or $40. Q uestion 3 (B-S O P M) Assume that you have been given the following information on Progen Holdings Ltd.: Current stock price = $15 Time to maturity of option = 6 months Variance of stock price = 0.12 d2 = 0.08165 Exercise price of option = $15 Risk-free rate = 10% d1 = 0.32660

Using the Black-Scholes Option Pricing Model (B-S OPM), what is the value of the option?

Q uestion 4 (B-S O P M) What is the value of the following call option according to the B-S OPM? Stock price = $27 Exercise price = $25 Time to expiration = 6 months Risk-free rate = 6% Stock return variance = 0.11

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T he Normal Distribution

OPM Questions

- A rea under the curve from -

[N(d)]

d -3.00 -2.95 -2.90 -2.85 -2.80 -2.75 -2.70 -2.65 -2.60 -2.55 -2.50 -2.45 -2.40 -2.35 -2.30 -2.25 -2.20 -2.15 -2.10 -2.05 -2.00 -1.95 -1.90 -1.85 -1.80 -1.75 -1.70 -1.65 -1.60 -1.55 -1.50 -1.45 -1.40 -1.35 -1.30 -1.25 -1.20 -1.15 -1.10 -1.05 -1.00

N(d) 0.0013 0.0016 0.0019 0.0022 0.0026 0.0030 0.0035 0.0040 0.0047 0.0054 0.0062 0.0071 0.0082 0.0094 0.0107 0.0122 0.0139 0.0158 0.0179 0.0202 0.0228 0.0256 0.0287 0.0322 0.0359 0.0401 0.0446 0.0495 0.0548 0.0606 0.0668 0.0735 0.0808 0.0885 0.0968 0.1056 0.1151 0.1251 0.1357 0.1469 0.1587

d -1.00 -0.95 -0.90 -0.85 -0.80 -0.75 -0.70 -0.65 -0.60 -0.55 -0.50 -0.45 -0.40 -0.35 -0.30 -0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00

N(d) 0.1587 0.1711 0.1841 0.1977 0.2119 0.2266 0.2420 0.2578 0.2743 0.2912 0.3085 0.3264 0.3446 0.3632 0.3821 0.4013 0.4207 0.4404 0.4602 0.4801 0.5000 0.5199 0.5398 0.5596 0.5793 0.5987 0.6179 0.6368 0.6554 0.6736 0.6915 0.7088 0.7257 0.7422 0.7580 0.7734 0.7881 0.8023 0.8159 0.8289 0.8413

d 1.05 1.10 1.15 1.20 1.25 1.30 1.35 1.40 1.45 1.50 1.55 1.60 1.65 1.70 1.75 1.80 1.85 1.90 1.95 2.00 2.05 2.10 2.15 2.20 2.25 2.30 2.35 2.40 2.45 2.50 2.55 2.60 2.65 2.70 2.75 2.80 2.85 2.90 2.95 3.00

N(d) 0.8531 0.8643 0.8749 0.8849 0.8944 0.9032 0.9115 0.9192 0.9265 0.9332 0.9394 0.9452 0.9505 0.9554 0.9599 0.9641 0.9678 0.9713 0.9744 0.9772 0.9798 0.9821 0.9842 0.9861 0.9878 0.9893 0.9906 0.9918 0.9929 0.9938 0.9946 0.9953 0.9960 0.9965 0.9970 0.9974 0.9978 0.9981 0.9984 0.9987