 Binomial option pricing model makes simplified assumption

of only two possible end-values of the underlying asset,

 one up (₹ 125, 25% up), with probability p and
 another down (₹ 80, 20% down with probability (1 – p)
from the current price (₹ 100).
Price of the Asset under Binomial Option Pricing Model
At t = 0 at t = 1
S1= 125
p

S0 = 100
(1 - p)
S1 = 80
  We value at-the-money European call
with a strike price, X of ₹ 100 and time
to expiry of one year.
 The payoff of call with strike price at X =
100 is
 At price of ₹ 125 : 125 -100 = ₹ 25,
 At price of ₹ 80 : 0
 Risk free return is 6% per annum.

.
 We find the expected value of the call at t = 1.
Then we discount the value of the call at t = 0.
 the probability of upside movement, p as 0.90.
 Therefore, the probability of downside movement (1-p)
is 0.10.
 Expected value of stock (at t = 1)
= 0.90 × 125 + 0.10 × 80 = ₹ 120.80
 Expected value of the call (at t = 1)
= Higher of (expected value of the stock - exercise
price, 0)
= 120.80 -100.00 = ₹ 20.80
 Value of the call today = 20.80/1.06 = ₹ 19.62
 Estimating the probability and finding the
expected value of the option is fallacious
because we do not know the appropriate
discount rate.
 The seemingly valid value of the call offers
arbitrage opportunity.
 For another investor who assigns a different
probability to up move will have a different
value of the call.
 With the value of the call at ₹ 19.62 one
arbitrageur can set up a portfolio of long five
shares and write (short) nine calls. The initial
investment would be:
Action Cash flow
Buy 5 shares = - 5 × 100 = - 500.00
Write 9 calls = + 9 × 19.62 = + 176.58
Cash outflow at t = 0 = ₹ 323.42
 The portfolio can be set up with borrowing at
6%.
 The liability would be 1.06 × 323.42 = ₹ 342.83
after a year.
With price at ₹ 125 With price at ₹ 80
 Value of stock would be  Value of stock would be
5 × 125 = ₹ 625 5 x 80 = ₹ 400
 The liability on calls written  The liability for the calls
would be 9 ×25 = ₹ 225. written is zero.
 The net cash inflow is ₹ 400.  Net cash flow is ₹ 400.
Portfolio Value at T =1
(All figures in Rupees)

T=1 5 Shares 9 Calls Total

125.00 625.00 -225.00 400.00
100
80.00 400.00 - 400.00
 Assigning different probabilities to up and
down movement with risk perception
(attaching higher/lower chances to price
moving upwards/downwards) would provide
different values to the call option.
 This would offer arbitrage.
 In such estimation of expected value the
discount rate used is not appropriate to the risk
assumed.
 Under risk neutrality we assume that the expected
value of the stock would provide return equal to
risk free rate, r. Therefore
E(S1) = (1+ r) x S0, or
E(S1) = ert x S0 with continuous compounding
 Alternatively stated we can value the derivative by
finding the risk neutral probabilities with which the
current market price is nothing but expected value of
the underlying asset discounted at risk free rate of
return.
 The valuation of the derivative on the asset too
can done assuming the same probabilities.
 Under binomial approach if the risk neutral
probability of the upward movement is p with a gain
of u%, and probability of the downward movement is
(1- p) with a loss of d% then the expected return
must equal risk free rate of return
r-d
p ×u + (1- p) × d = r, or p =
u-d
 If risk free rate is 6%, u = 25% and d = -20%,
then probability of the up movement implied, p is
r - d 6 - (-20)
p= = = 0.5778 =57.78%
u - d 25 - (-20)
 From the implied probabilities we may value the
call option as expected value of the payoff.

Value of the call at the end of the option period

= Prob. of up movement × Payoff
+ Prob. of down movement × Payoff
= p × Max (S1 - X, 0) + (1 - p) × Max (S1 - X, 0)

Hence value of the call at the end of one year

would be:
= 0.5778 × 25 + 0.4222 × 0 = ₹ 14.44
The value of the call today is 14.44/1.06 = ₹ 13.63.
 Under the risk neutral approach we
found
 The risk neutral implied probabilities of up
and down movement,
 Then, calculated the expected payoff of the
option at maturity with implied probabilities,
and
 Finally, discounted the expected payoff at
the risk free rate to arrive at the current
value of the option.
 An alternate way under risk neutral valuation is
to construct a portfolio of buying some shares
by borrowing so as to have the same payoff as
that of the call option.
 The portfolio of share and borrowing can be
valued easily with the interest rate and the
spot prices known.
 This can be set equal to the price of the call
option.
 Spread of call option 25 – 0 25 5
Option Delta = = = =
Spread of share price 125 – 80 45 9

 Portfolio of 5/9 share and a borrowing that matures to ₹ 44.44

after a year would have following payoff:
Share Price 125.00 80.00
Value of 5/9 share (₹) 69.44 44.44
Maturity value of loan (₹) - 44.44 - 44.44
Value of the portfolio at maturity 25.00 0.00
Payoff of call option (₹) 25.00 0.00
 Payoffs of portfolio and call are same hence they must be
priced same. Value of call today equals portfolio value today.
= Value of the 5/9 share today - Value of the loan today
= 5/9 × 100 - 44.44/1.06 = 55.55 - 41.92 = ₹ 13.63
 For pricing put we set up a portfolio of long one
share and M puts with X = 100. Value of portfolio is:
Binomial Put Pricing
One Share & M Puts
125 125
100
80 80 + 20 x M

 Equating final values gives M = 2.25.

 Setting this portfolio of one share and 2.25 puts to
yield a risk free return must give the value of the put,

(100 + 2.25 x p’) ×1.06 = 125 or p’ = ₹ 7.97

 Option delta helps in construction of riskless
portfolio and therefore used in valuation of
options.
 Under equivalent portfolio approach we
proceeded as below:
 Calculated the option delta, Δ
 Set up the portfolio of
 Δ shares and one short call or
 Δ shares and one long puts,
 Found the values of portfolio at the end and its
present value,
 Equated the present value with the cost of
portfolio to solve for the value the option.
 A two-period binomial model with 25% up and
20% down movement is as below:
Two Period Binomial Tree
VALUES (₹)
Stock Call X = 100
156.25 56.25
+ 25%
125
+25% - 20%
100
100.00 0.00

- 20 % + 25%
80
- 20 %
64.00 0.00
T=0 T=1 T=2
 From the values at T = 2 we work backwards to
value the call using risk neutral probabilities and risk
free rate.
 Risk neutral probabilities are 0.5778 and 0.4222 for
up and down movements respectively.
Value of call option for Upper Node at T = 1
Value of call at T = 2: 0.5778 x 56.22 + 0.4222 x 0 = ₹ 32.48
Value of call at T = 1: 32.48/1.06 = ₹ 30.65
Value of call option for Upper Node at T = 1
Value of call at T = 2: 0.5778 x 0 + 0.4222 x 0 = 0
Value of call at T = 1: Zero
Value of call option for Node at T = 0
= 1/1.06(.5778 x 30.65 + 0.4222 x 0) = 17.71/1.06 = ₹ 16.71
To improve accuracy of the option pricing
 Binomial model can be extended to multi-periods to
broaden the range of end-values.
 For computational ease it is desired that prices at
each binomial tree should converge to the original
value. This is achieved by making up and down
movements reciprocal of each other.
 If up move is 25% then the down move is 1/1.25 = 0.80
(25% rise and 20% fall).
 As we increase the number of trees by shortening the
time interval the option price under binomial model
moves closer and closer to analytical model such as
Black Scholes.
 An American call is no greater in value than an
equivalent European call as by exercising early
one gets the intrinsic value only and loses the
time value of the option.
 We may use multi-period binomial model to
value options by:
 Computing the risk neutral probabilities of up and
down movement, then
 Using the probabilities and starting backwards, we find
the expected payoff of the option at preceding node, and
 Discounting the payoff at risk free rate to find the
value at that node.
 Proceeding with all steps till node T = 0 is reached.
 For American call exercise of option before maturity does not make any
difference in valuation, and its value is same as European call.
 We may use multi-period model to value American put by comparing the
value one gets by exercising with that of not exercising, and retaining the
higher of the two, at each node.
 The process is summarized as below:
 Computing the risk neutral probabilities of up and down movement,
then
 Using these probabilities and starting backwards, we find the expected
payoff of the option at preceding node, and
 Comparing risk-neutral values with the payoff if exercised at each
node, with higher of the two retained, and
 Discounting the payoff at risk free rate to find the value at that node
 The process is repeated till the last node is reached.
 Binomial model can be extended to currency
options with small modification in the risk free
rate.
 While valuing currency option the interest rate must
be considered net of foreign interest rate.
 If the domestic risk free interest rate is 10% p.a.
and that in foreign currency is 4% p.a. then while
computing the risk neutral probabilities the interest
rate that must be used is 6% (10% - 4%); the
differential of the two.
 Binomial model can also be extended to index
options again with small modification in the risk
free rate.
 While valuing index option the interest rate
must be considered net of dividend yield on
the index.
 If the risk free interest rate is 8% p.a. and the
dividend yield on index is 3% p.a. then while
computing the risk neutral probabilities the
interest rate that must be used is 5% (8% - 3%);
the differential of the two.
 The current value of NIFTY is 4,500. In a period of 3 months it
can go up or down by 10%. Risk free interest rate is 8% and
dividend yield is 2%. Value of 3-m call and put with X = 4600
using single stage binomial model and 1point= ₹ 1.
Solution
 3-m European call and put with X = 4,600 can be valued
with risk neutral valuation with net interest rate of 6%.
 The risk neutral probabilities are:
rf t 0.06x3/12
e - (1 - d) e (1 - 0.10)
p = =
u-d 0.10 + 0.10
1.0151- 0.90
= = 0.5756 = 57.56%
0.20
1- p = 1 - 0.5756 = 0.4244
Risk Neutral Valuation of Index Options (Figures in Rupees)
T=3m Spot Call X = 4600 Put X = 4600
p= 0.5756 4,950 350 -
4,500
1- p = 0.4244 4,050 - 550

Value of call
At T = 3 m = 350 x 0.5756 + 0 x 0.4244 = 201.45
At T = 0: = 201.45 x e-0.06 x3/12 = 201.45 x 0.9851 = ₹ 198.45
Value of put
At T = 3 m: =0 x 0.5756 + 550 x 0.4244 = 233.44
At T = 0: = 233.44 x e -0.06 x 3/12 = 233.44 x 0.9851 = ₹ 229.96
 Binomial model has following limitations:
 Too unrealistic for determination of fair value.
 The probability distribution seems far from reality.
 The primary determinant of the option value i.e. the
volatility in the implied probability of the binary states.
 However, in actual practice they are
overcome as follows:
 By adding binomial periods usually around 30 small
intervals.
 With 30 intervals we have 31 different terminal prices.
 There would be 230 different paths to achieve these
31 terminal prices.
 The probability of maximum price and minimum price is
1/230. The next level of prices would consist of 29 up
moves and one down move. It is possible to achieve it in
30 different ways i.e. 30C1. The probability iwill be 30C1 / 230.
 Similarly we may find the probability of each of the 31
possible terminal prices. Thus probability distribution would
be far closer to reality than what one imagines in binary
state.
 The way to overcome the objection of absence of volatility is
to incorporate the stock volatility in the binary model. It is
possible to equate the up or down move based on stock
volatility, σ.
 For
n stage binomial trees,
j up moves of d, and
n – j moves of d, and
probability of up move of p
the call value is given by
n
n!
∑
0 (n - j)! j!
p j (1 − p)n− j Max (0,u j d n− j S − X)
c0 =
(1 + r) n