Binomial options pricing model

From Wikipedia, the free encyclopedia

BOPM redirects here; for other uses see BOPM (disambiguation). In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. The binomial model was first proposed by Cox, Ross and Rubinstein(1979). Essentially, the model uses a discrete-time (lattice based) model of the varying price over time of the underlying financial instrument. In general, binomial options pricing models do not have closedform solutions.
Contents
[hide]

1 Use of the model 2 Method

o o o

2.1 STEP 1: Create the binomial price tree 2.2 STEP 2: Find Option value at each final node 2.3 STEP 3: Find Option value at earlier nodes

2.3.1 Discrete dividends

3 Relationship with BlackScholes 4 See also 5 Notes 6 References 7 External links

o o o

7.1 Discussion 7.2 Variations 7.3 Computer implementations

[edit]Use

of the model

The Binomial options pricing model approach is widely used as it is able to handle a variety of conditions for which other models cannot easily be applied. This is largely because the BOPM is based on the description of an underlying instrument over a period of time rather than a single point. As a consequence, it is used to value American options that are exercisable at any time in a given interval as well as Bermudan options that are exercisable at specific instances of time. Being relatively simple, the model is readily implementable in computer software (including a spreadsheet). Although computationally slower than the Black Scholes formula, it is more accurate, particularly for longerdated options on securities with dividend payments. For these reasons, various versions of the binomial model are widely used by practitioners in the options markets. For options with several sources of uncertainty (e.g., real options) and for options with complicated features (e.g., Asian options), binomial methods are less practical due to several difficulties, andMonte Carlo option models are commonly used instead. When simulating a small number of time steps Monte Carlo simulation will be more computationally time-consuming than BOPM (cf. Monte Carlo methods in finance). However, the worst-case runtime of BOPM will be O(2n), where n is the number of time steps in the simulation. Monte Carlo simulations will generally have a polynomial time complexity, and will be faster for large numbers of simulation steps. Monte Carlo simulations are also less susceptible to sampling errors, since binomial techniques use discrete time units. This becomes more true the smaller the discrete units become. [edit]Method

The binomial pricing model traces the evolution of the option's key underlying variables in discrete-time. This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in time. Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time. Option valuation using this method is, as described, a threestep process: 1. price tree generation, 2. calculation of option value at each final node, 3. sequential calculation of the option value at each preceding node. [edit]STEP

1: Create the binomial price tree

The tree of prices is produced by working forward from valuation date to expiration. At each step, it is assumed that the underlying instrument will move up or down by a specific factor ( or ) per step of the tree (where, by definition, and ). So, if is the current price, then in the next period the price will either be or . The up and down factors are calculated using the underlying volatility, , and the time duration of a step, , measured in years (using the day count convention of the underlying instrument). From the condition that the variance of the log of the price is , we have:

The above is the original Cox, Ross, & Rubinstein (CRR) method; there are other techniques for generating the lattice, such as "the equal probabilities" tree. The Trinomial tree is a similar model, allowing for an up, down or stable path. The CRR method ensures that the tree is recombinant, i.e. if the underlying asset moves up and then down (u,d), the price will be the same as if it had moved down and then up (d,u) here the two paths merge or recombine. This property reduces the number of tree nodes, and thus accelerates the computation of the option price. This property also allows that the value of the underlying asset at each node can be calculated directly via formula, and does not require that the tree be built first. The node-value will be:

Where

is the number of up ticks and

is the

number of down ticks. [edit]STEP

2: Find Option value at each final node

At each final node of the tree i.e. at expiration of the option the option value is simply its intrinsic, or exercise, value. Max [ ( Max [ ( ), 0 ], for a call option ), 0 ], for a put option: Where is the strike price and is the spot price of the underlying asset at the period. [edit]STEP

3: Find Option value at earlier nodes

Once the above step is complete, the option value is then found for each node, starting at the penultimate time step, and working back to the first node of the tree (the valuation date) where the calculated result is the value of the option. In overview: the binomial value is found at each node, using the risk neutrality assumption; see Risk neutral valuation. If exercise is permitted at the node, then the model takes the greater of binomial and exercise value at the node. The steps are as follows: (1) Under the risk neutrality assumption, today's fair price of a derivative is equal to the expected value of its future payoff discounted by the risk free rate. Therefore, expected value is calculated using the option values from the later two nodes (Option up and Option down) weighted by their respective probabilities probability p of an up move in the underlying, and probability (1-p) of a down move. The expected value is then discounted at r, the risk free rate corresponding to the life of the option. The following formula to compute the expectation value is applied at each node: Binomial Value = [ p Option up + (1-p) Option down] exp (- r t), or where is the option's value for the node at time ,

is chosen such that the related binomial distribution simulates the geometric Brownian motion of the underlying stock with parameters r and , is the dividend yield of the underlying corresponding to the life of the option. It follows that in a risk-neutral world futures price should have an expected growth rate of zero and therefore we can consider for futures. Note that for condition on to be in the interval has to be satisfied the following .

(Note that the alternative valuation approach, arbitragefree pricing, yields identical results; see delta-hedging.) (2) This result is the Binomial Value. It represents the fair price of the derivative at a particular point in time (i.e. at each node), given the evolution in the price of the underlying to that

point. It is the value of the option if it were to be heldas opposed to exercised at that point. (3) Depen ding on the style of the option, evaluate the possibility of early exercise at each node: if (1) the option can be exercised, and (2) the exercise value exceeds the Binomial Value, then (3) the value at the node is the

exercise value.

For a Euro pean option, there is no option of early exercis e, and the binomi al value applies at all nodes.

For an Am erican option, since the option may either be held or exercis ed prior to expiry, the

value at each node is: Max (Binomi al Value, Exercis e Value).

For a Berm udan option, the value at nodes where early exercis e is allowed is: Max (Binomi al Value, Exercis e Value); at nodes where early exercis

e is not allowed , only the binomi al value applies . In calculating the value at the next time step calculated i.e. one step closer to valuation the model must use the value selected here, for Option up/Optio n down as appropriat e, in the formula at the node. The following al gorithm de

monstrates the approach computing the price of an American put option, although is easily generalize d for calls and for European and Bermudan options:
function americanP ut(T, S, K, r, sigma, q, n) { ' T... expiratio n time ' S... stock price ' K... strike price ' n...

height of the binomial tree

deltaT := T / n; up := exp(sigma * sqrt(delt aT)); p0 := (up * exp(-r * deltaT) exp(-q * deltaT)) * up / (up^2 1); p1 := exp(-r * deltaT) p0; ' initial values at time T for i := 0 to n { p[i] := K - S * up^(2*i n);

if p[i] < 0 then p[i] := 0; } ' move to earlier times for j := n-1 down to 0 { for i := 0 to j { p[i] := p0 * p[i] + p1 * p[i+1]; ' binomial value exercise := K - S * up^(2*i - j); value if p[i] < exercise then p[i] := exercise; } ' exercise

return americanP ut := p[0]; }

[edit]Disc

rete dividend s
In practice, the use of continuous dividend yield, , in the formula above can lead to significant mis-pricing of the option near an exdividend d ate. Instead, it is common to model dividends as discrete

payments on the anticipated future exdividend dates. To model discrete dividend payments in the binomial model, apply the following rule:

At each time step, , calculat e , for all where is the present value of the th dividen

d. Subtra ct this value from the value of the securit y price at each node ( , ). [edit]Rel

ationsh ip with Black Schole s

Similar ass umptions u nderpin both the binomial model and the Black Scholes model, and the binomial model thus provides a

discrete time approximat ion to the continuous process underlying the Black Scholes model. In fact, for Europe an options wit hout dividends, the binomial model value converges on the Black Scholes formula value as the number of time steps increases. The binomial model assumes that movement

s in the price follow a binomial distribution ; for many trials, this binomial distribution approache s the normal distribution assumed by Black Scholes. In addition, when analyzed as a numerical procedure, the CRR binomial method can be viewed as a special case of the explicit finite difference method for the Black Scholes

PDE; see Finite difference methods for option pricing.[citati

on needed]

In 2011, Georgiadis shows that the binomial options pricing model has a lower bound on complexity that rules out a closedform solution

BlackScholes
From Wikipedia, the free encyclopedia

The BlackScholes model (pronounced /blk olz/[1]) or BlackScholes-Merton is a mathematical model of a financial market containing certain derivative investment instruments. From the model, one can deduce the BlackScholes formula, which gives the price of European-style options. The formula led to a boom in options trading and the creation of the Chicago Board Options Exchange[dubious discuss]. lt is widely used

by options market participants.[2]:751 Many empirical tests have shown the Black Scholes price is fairly close to the observed prices, although there are well-known discrepancies such as the option smile.[2]:770-771 The model was first articulated by Fischer Black and Myron Scholes in their 1973 paper, The Pricing of Options and Corporate Liabilities. They derived a partial differential equation, now called theBlackScholes equation, which governs the price of the option over time. The key idea behind the derivation was to hedge perfectly the option by buying and selling the underlying asset in just the right way and consequently "eliminate risk". This hedge is called delta hedging and is the basis of more complicated hedging strategies such as those engaged in by Wall Street investment banks. The hedge implies there is only one right price for the option and it is given by the Black Scholes formula. Robert C. Merton was the first to publish a paper expanding the mathematical understanding of the options pricing model and coined the term BlackScholes options pricing model. Merton and Scholes received the 1997 Nobel Prize in Economics (The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) for their work. Though ineligible for the prize because of his death in 1995, Black was mentioned as a contributor by the Swedish academy.[3]
Contents
[hide]

1 Assumptions 2 Notation 3 The BlackScholes equation

o

3.1 Derivation

4 BlackScholes formula
o o

4.1 Interpretation 4.2 Derivation

4.2.1 Other derivations

5 The Greeks 6 Extensions of the model

o o

6.1 Instruments paying continuous yield dividends 6.2 Instruments paying discrete proportional dividends

7 BlackScholes in practice
o o o o

7.1 The volatility smile 7.2 Valuing bond options 7.3 Interest rate curve 7.4 Short stock rate

8 Criticism 9 Remarks on notation 10 See also 11 Notes 12 References

o o o

12.1 Primary references 12.2 Historical and sociological aspects 12.3 Further reading

13 External links
o o o o o

13.1 Discussion of the model 13.2 Derivation and solution 13.3 Revisiting the model 13.4 Computer implementations 13.5 Historical

[edit]Assumptions The BlackScholes model of the market for a particular stock makes the following explicit assumptions:

There is no arbitrage opportunity (i.e., there is no way to make a riskless profit). It is possible to borrow and lend cash at a known constant risk-free interest rate. It is possible to buy and sell any amount, even fractional, of stock (this includes short selling). The above transactions do not incur any fees or costs (i.e., frictionless market). The stock price follows a geometric Brownian motion with constant drift and volatility.

The underlying security does not pay a dividend.[4]

From these assumptions, Black and Scholes showed that it is possible to create a hedged position, consisting of a long position in the stock and a short position in the option, whose value will not depend on the price of the stock.[5] Several of these assumptions of the original model have been removed in subsequent extensions of the model. Modern versions account for changing interest rates (Merton, 1976)[citation needed],transaction costs and taxes (Ingersoll, 1976)[citation needed], and dividend payout.[6] [edit]Notation Let , be the price of the stock (please note as below). , the price of a derivative as a function of time and stock price. the price of a European call option and the price of a European put option. , the strike of the option. , the annualized risk-free interest rate, continuously compounded. , the drift rate of , annualized. , the volatility of the stock's returns; this is the square root of the quadratic variation of the stock's log price process. , a time in years; we generally use: now=0, expiry=T. , the value of a portfolio. Finally we will use which

denotes the standard normal cumulative distribution function,

which denotes the standard normal probability density function,

. [edit]The

Black Scholes equation

Simulated Geometric Brownian Motions with Parameters from Market Data

As above, the Black Scholes equation is a partial differential equation, which describes the price of the option over time. The key idea behind the equation is that one can perfectly hedge the option by buying and selling the underlying asset in just the right way and

consequently eliminate risk". This hedge, in turn, implies that there is only one right price for the option, as returned by the BlackScholes formula given in the next section. The Equation:

[edit]Derivation The following derivation is given in Hull's Options, Futures, and Other Derivatives.[7]:287
288

That, in turn, is based on the classic argument in the original Black Scholes paper. Per the model assumptions above, the price of the underlying asset (typically a stock) follows a geometric Brownian motion. That is,

where W is Brown ian motion. Note that W, and

consequently its infinitesimal increment dW, represents the only source of uncertainty in the price history of the stock. Intuitively, W(t) is a process that jiggles up and down in such a random way that its expected change over any time interval is 0. (In addition, its variance over time T is equal to T); a good discrete analogue for W is a simple random walk. Thus the above equation states that the infinitesimal rate of return on the stock has an expected value of dt and a variance of The payoff of an option at maturity is .

known. To find its value at an earlier time we need to know how evolves as a function of and . By It's lemma for two variables we have

Now consider a certain portfolio, called the deltahedge portfoli o, consisting of being short one option and long shares at time . The value of these holdings is

Over the time period , the total profit or

loss from changes in the values of the holdings is:

Now discreti ze the equatio ns for dS/ S and dV by replaci ng differen tials with deltas:

a n d a p p r o

p r i a t e l y s u b s t i t u t e t h e m i n t o t h e e x

p r e s s i o n f o r

N o t i c e t h a t t h e

t e r m h a s v a n i s h e d . T h u s u n c e r t a i n t y

h a s b e e n e l i m i n a t e d a n d t h e p o r t f o l i

o i s e f f e c t i v e l y r i s k l e s s . T h e r a t e

o f r e t u r n o n t h i s p o r t f o l i o m u s t b e

e q u a l t o t h e r a t e o f r e t u r n o n a n y o

t h e r r i s k l e s s i n s t r u m e n t ; o t h e r w i s e ,

t h e r e w o u l d b e o p p o r t u n i t i e s f o r a r

b i t r a g e . N o w a s s u m i n g t h e r i s k f r e e

r a t e o f r e t u r n i s

w e m u s t h a v e o v e

r t h e t i m e p e r i o d

I f w e n o w e q u a t

e o u r t w o f o r m u l a s f o r

w e o b t a i n :

S i m p l i f y i n g , w e a r r i v e a t t h e c e l

e b r a t e d B l a c k S c h o l e s p a r t i a l d i f f e r

e n t i a l e q u a t i o n :