3.3.6 Binomial Trees

6. Binomial Trees

6.1 One-step Binomial Trees

6.1.1 Definition of Binomial Model

Binomial model: after one period, the value of the underlying asset will either go up to $S_u$ or go down $S_d$.

6.1.2 No-arbitrage Argument

Law of one price: Assets that produce identical(完全相同的) future cash flows regardless of future everts should have the same price.

We can use option and stock to construct a portfolio which has certain value after one period. If there is no arbitrage opportunity, the option price can be derived from the cost of this portfolio.

Example: The stock is currently trading at $ $50$. The stock price will either go up to $ $75$ or go down to $ $25$ after one year. The risk-free rate is $2\%$. Please calculate the value of a 1-year European call option with an exercise price of $ $60$ using one-step binomial tree.

We create risk-neutral portfolio, Long $\Delta$ stock and short $1$ call option.

The value of the portfolio after 1 year: $\Delta \ast S_u-C_u=\Delta \ast S_d-C_d\to \Delta =0.3$

The portfolio value at $t_0$: $50\times 0.3-c$

The portfolio value at $t_1$: $75\times 0.3-15=7.5$

Thus, $(50\times 0.3-c)\times e^{0.02}=7.5\to c=7.6485$

Calculata $\Delta$ of a stock option: $\Delta \times S_u-C_u=\Delta \times S_d-C_d$

$$\Delta =\frac{C_u-C_d}{S_u-S_d}$$

6.1.3 Risk Neutral Valuation

In a risk neutral world, all individuals are indifferent to risk. Investors requires no compensation for risk and expected return on all securities is the risk-free interest rate.

The option should be valued based on risk neutrality.

In a risk-neutral world, the expected return on all securities is the risk-free interest rate, and the discount rate is the risk-free interest rate.

$$u=e^{\sigma \sqrt{t}},d=\frac{1}{u}=e^{-\sigma \sqrt{t}}$$

The higher the standard deviation, the greater the dispersion between stock prices in up and down states.
$${\pi }_u\times S_0\times u+(1-{\pi }_u)\times S_0\times d=S_0{e}^{rt}\to {\pi }_u=\frac{e^{rt}-d}{u-d}$$

6.1.4 Risk neutral valuation-Process

The valuation process of one-step binomial tree as follow:

• Calculate $u$ and $d$, then construct the whole binomial tree.
• Calculate the payoff of the option at the maturity node.
• Compute the risk-neutral up and down probability, then calculate the expected value of option in one period.
• Use risk-free rate to discount the expected value to present.

6.2 Two-step Binomial Trees

6.2.1 Two-Step Binomial Model

The basic valuation process of a two-step European option is similar with one-step binomial model, but with more steps.

6.2.2 Two-Step Binomial Model - European

An analyst is using two-step binomial model to calculate the price of a 2-year European put option with strike price of $ $75$. The continuously compounded risk-free rate is $5\%$. The stock pays no dividend and is trading at $ $70$. The volatility of the stock price is $20\%$. What will be the European put option price?

Firstly, calculate $u$ and $d$, then construct the whole binomial trees:
$$u=e^{\sigma \sqrt{T}}=e^{0.02\ast \sqrt{1}}=1.2214,d=\frac{1}{u}=e^{-\sigma \sqrt{T}}=0.8187$$

Secondly, calculate the payoff of the option at the maturity node:

Thirdly, compute the risk-neutral up and down probability, and then calculate the expected value in one period.
$${\pi }_u=\frac{e^{rt}-d}{u-d}=\frac{e^{5\%\times 1}-0.8187}{1.2214-0.8187}=57.7529\%$$
$${\pi }_d=1-{\pi }_u=1-57.7528\%=42.2471\%$$

At last, use risk-free rate to discount the expected value to present.
$\text{Node}2=(0\times 57.7529\%+5\times 42.2471\%)e^{-5\%}=2.0093$

$\text{Node}3=(5\times 57.7529\%+28.0811\times 42.2471\%)e^{-5\%}=14.0317$

$\text{Node}1=(2.0093\times 57.7529\%+14.0317\times 42.2471\%)e^{-5\%}=6.7427$

The European Put Option price is $6.7427$

6.2.3 Two-Step Binomial Model - American

We need to determine if the option will be exercised at each node including Node 1.

$$\text{Node}1=(2.0093\times 57.7529\%+17.691\times 42.2471\%)e^{-5\%}=8.2133$$

Node1 should also be checked. In this case, if there is an early exercise in Node 1, payoff will be 5 which is less than 8.2133. Therefore, the option will not be exercised early in Node 1 and value of this American put option is 8.2133.

6.2.4 As time periods are added

Suppose that a binomial tree with $n$ steps in its life T, if $n$ approaches infinity, the length of each step approaches to zero. A continuous binomial tree will be achieved and this is one of the ways that derive the Black-Scholes-Merton model.

6.2.5 Options on Other Assets

Options on stock indices with continuous dividend yield $q$

$${\pi }_u\times S_0\times u+(1-{\pi }_u)\times S_0\times d=S_0{e}^{(r-q)t}$$
$${\pi }_u=\frac{e^{(r-q)t}-d}{u-d}$$

Options on currencies with thedomestic risk-free rate $R_{\text{DC}}$ and foreign risk-free rate $R_{\text{FC}}$

$${\pi }_u=\frac{e^{(r_{\text{DC}}-r_{\text{FC}})t}-d}{u-d}$$

Option on futures
$${\pi }_u=\frac{1-d}{u-d}$$