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    Op2 95

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    Raman Iyer
    The document discusses binomial option pricing models. It introduces a multi-period binomial model where the stock price can move up (u) or down (d) each period. It shows how to derive the option price C by constructing a replicating portfolio of stock D and riskless bonds B. The value of C depends only on the risk-neutral probability p, not the subjective probability q. The model can be extended to multiple time periods using a recursive procedure. It also introduces the Black-Scholes model for pricing options.

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    Op2 95

    Uploaded by

    Raman Iyer
    47 views17 pages
    The document discusses binomial option pricing models. It introduces a multi-period binomial model where the stock price can move up (u) or down (d) each period. It shows how to derive the option price C by constructing a replicating portfolio of stock D and riskless bonds B. The value of C depends only on the risk-neutral probability p, not the subjective probability q. The model can be extended to multiple time periods using a recursive procedure. It also introduces the Black-Scholes model for pricing options.

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    Option Pricing 2

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    Op2_95

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    The document discusses binomial option pricing models. It introduces a multi-period binomial model where the stock price can move up (u) or down (d) each period. It shows how to derive the option price C by constructing a replicating portfolio of stock D and riskless bonds B. The value of C depends only on the risk-neutral probability p, not the subjective probability q. The model can be extended to multiple time periods using a recursive procedure. It also introduces the Black-Scholes model for pricing options.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    47 views17 pages

    Op2 95

    Uploaded by

    Raman Iyer
    The document discusses binomial option pricing models. It introduces a multi-period binomial model where the stock price can move up (u) or down (d) each period. It shows how to derive the option price C by constructing a replicating portfolio of stock D and riskless bonds B. The value of C depends only on the risk-neutral probability p, not the subjective probability q. The model can be extended to multiple time periods using a recursive procedure. It also introduces the Black-Scholes model for pricing options.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 17

    Option Pricing II

    Binomial Option Pricing


    Consider a world with a risky stock and a riskfree
    bond.
    Let the riskfree return be r-1.
    Let the stock give a return u - 1 with probability q
    and a return d - 1 with probability 1 - q.
    It is easy to see that u > r > d.
    uS
    q
    S
    1-q

    dS
    Binomial Option Pricing
    uS
    q
    S
    1-q

    dS

    Cu Max0, uS K
    q
    C
    1-q
    Cd Max0, dS K
    Binomial Option Pricing
    To get a handle on the value of this call option, we
    attempt to construct an equivalent portfolio of
    the underlying stock and the riskfree bond.
    If we are able to construct such a portfolio, we can
    value it, and, given no-arbitrage, value the call
    option.
    Buying stock and then leveraging the position by
    borrowing at the riskfree rate may help.
    Suppose we buy D stocks and B bonds. What is
    our payoff?
    Binomial Option Pricing
    DuS+rB
    q
    DS+B
    1-q
    DdS+rB

    Cu
    q
    C
    1-q
    Cd
    Binomial Option Pricing
    For the two portfolios to be equivalent, we must have:
    D uS rB Cu
    D dS rB Cd

    Solving for the unknowns D and B we get:


    C Cd
    D u
    u d S
    uCd dCu
    B
    u d r
    Binomial Option Pricing

    With no arbitrage, the following must hold:


    C DS B
    Cu Cd uCd dCu
    S u d r
    u d S
    1 r d ur
    Cu Cd

    r ud u d
    Binomial Option Pricing
    C
    1
    r

    p Cu 1 p Cd
    where
    rd
    p , and
    ud
    ur
    ud
    1 p
    Binomial Option Pricing
    C
    1
    r

    p Cu 1 p Cd
    where
    rd
    p , and
    ud
    ur
    ud
    1 p

    Note that q does not appear here and investors


    agree on the relation between C, S and r.
    The value of the call is free of investors attitude
    toward risk.
    Example
    Suppose DEC's current share price is $87. A call
    option on DEC with exercise price $90 matures in
    2 weeks.
    You believe that DEC's performance over the next
    two weeks is closely linked with the housing starts
    report. A positive report could mean a stock price
    as high as $94 at option maturity and a negative
    report could mean a price as low as $83.
    If the riskfree rate over two weeks is 0.3%, price
    the call option. Obtain D and B.
    Solution
    We have d = 0.954, u = 1.081, r = 1.003. Why?
    Cu = 4, Cd = 0. Explain.
    D = ? and B = ?
    D = 0.362 and B = -29.957.
    Therefore, the equivalent portfolio requires that you buy
    $31.494 worth of stock and borrow $29.957 to finance part
    of the purchase. This requires you put in $1.537.
    If stock price hits $83, your position is worth zero. If it
    hits $94, your position is worth $4.
    What is C then? C = 0.362 x 87 + (-29.957) = $1.537.
    Option Pricing: Two Subperiods


    Cuu Max 0, u2 S K
    Cu
    C Cud Max0, udS K

    Cd

    Cdd Max 0, d 2 S K
    Option Pricing: Two Subperiods
    Cu
    1
    r

    p Cuu 1 p Cud

    Cd p Cud 1 p Cdd
    1
    r

    r
    1

    C 2 p2 Cuu 2 p 1 p Cud 1 p Cdd
    2

    C 2
    1
    p2 Max 0, u2 S K 2 p 1 p Max0, udS K


    r 1 p2 Max 0, d 2 S K

    Option Pricing: n Subperiods

    1 n
    C n
    n!
    p 1 p
    r j 0 j ! n j !
    j n j j
    Max 0, u dn j
    S K

    n n j u d
    j n j
    p 1 p
    n!
    C S j

    j 0 j ! n j ! r n

    n n j
    p 1 p
    n n!
    Kr j

    j 0 j ! n j !
    Black Scholes Model

    C S N d1 Kr n N d2

    d1

    ln S K r 2 2 T
    T
    d2 d1 T
    N d1, N d1 = cumulative normal probabilities
    2 = annualized variance of the
    continuously compounded return
    r = continuously compounded risk - free rate
    Example
    Suppose CBS's current share price is $164.
    A call option on CBS with exercise price $165
    matures in 35 days.
    Also suppose annualized variance of stock return
    is 0.0841.
    Finally, riskfree rate based on a T-Bill with 30
    days to expiration is 5.35%.
    What is the theoretical price of the call option?
    Solution
    Continuously compounded rate ln(10535
    . ) 0.0521
    = 0.29
    ln164 / 165 0.0521 0.0841 / 2 0.0959
    d1 0.0328
    0.29 0.0959
    d2 0.0328 0.29 0.0959 0.0570

    N d1 N 0.0328 0.5120

    N d2 N 0.0570 0.4761

    C 164 0.5120 165 e 0.0521 0.0959 0.4761 5.803

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