Bbands

Theory
Source: Hull, John C., Options, Futures & Other Derivatives. Fourth edition (2000). Prentice-Hall. P. 201f
S0u - ending stock price in an upward move

fu - payoff option in upward move
S0 - initial stockprice
f - value of option
S0d - ending stock price in an downward move
fd - payoff option in downward move
Risk Neutral Valuation

∆: long position of ∆ shares and short position of one option (-f) that makes portfolio riskless
f u− f d
S 0 uΔ− f u=S 0 dΔ− f d ⇒ Δ=
S 0 u−S 0 d
A riskless portfolio with a certain payoff of S0u∆ in time T must earn the riskless rate (r):
f u− f d
S 0 Δ− f = S 0 uΔ− fu  e−rT ⇒ Δ=
S 0 u−S 0 d
Solving for f (the value of the option)
f =e−rT  pf u −  1− p   f d 
where
e rT −d
p=
u−d
It is natural to interpret p as the probability of an up movement and 1-p as a probablity of a down movement.
Two-step binomial tree

f =e−2 rΔ t p 2 f u u2 p 1− p  f u d  1− p  f d d
2

S0u2 - ending stock two upward moves
fuu - payoff option in two upward moves
Su
fu
S0 - initial stockprice S0ud - ending stock one upward/one downward m
f - value of option fud - payoff option in one upward/one downward m
Sd
fd
S0d2 - ending stock two downward moves

fdd - payoff option in two downward moves
S0d2 - ending stock two downward moves
fdd - payoff option in two downward moves
∆t ∆t
Determination of p, u and d
Source: Hull, John C., Options, Futures & Other Derivatives. Fourth edition (2000). Prentice-Hall.
Chapter "Matching Volatility with u and d", P. 213.
In practice, when constructing a binomial tree to represent the movements in a stock price, we
choose parameters u and d to match the volatility of the stock price (σ ).
Cox, Ross & Rubinstein (1979) propose the following values of u and d to match volatility σ .
(Note that σ is the annualized standard deviation of return on the stock price)
σ  Δt −σ  Δt e−rΔt −d
u=e ; d =e ; p=
u−d
ce-Hall. P. 201f
u>1: Su value of stock in upward move

d<1: Sd value of stock in downward move
a down movement.
ck two upward moves

in two upward moves
ock one upward/one downward moves

in one upward/one downward moves
ock two downward moves

n in two downward moves
ock two downward moves
n in two downward moves
Simplified Numerical Example
Source: Hull, John C., Options, Futures & Other Derivatives. Fourth edition (2000). Prentice-Hall. P. 646f
Reference: Tsiverotis, K. Fernandes, C. "Valuing Convertibel Bonds with credit Risk", Journal of Fixed Income, vol. 8, no. 2
CB / share parameters:
S (Current share price) $20.00 Tree parameters

σ (sigma) p.a. 30% ∆t 0.250 ∆T = T / Time_steps
Conversion Ratio (n) 5 u 1.1618 u = EXP(σ*∆T^0.5)
Riskfree rate 10.00% d 0.8607 d = EXP(-σ*∆T^0.5)
T (time to CB maturity) 0.750 p 0.5466 p = [ exp((r-q)∆T) - d ] / (u -d)
Face value (FcV) $100.00
Bond yield 15.00%
Call value 115%
Dividend yield (q)
Tree without consideration of forced conversion Tree with consideration of forced con
t 0 0.25 0.5 0.750 0 0.25
n 0 1 2 3 0 1
S ($) $20.00 $23.24 $27.00 $31.37 $20.00 $23.24

Equity component $67.57 $99.36 $134.99 $156.83 $76.54 $116.18
Debt Component $38.45 $19.07 $- $- $28.41 $-
Total CB value $106.02 $118.42 $134.99 $156.83 $104.95 $116.18
2 $17.21 $20.00 $23.24 $17.21
$33.02 $61.94 $116.18 $33.02
$65.05 $43.67 $- $65.05
$98.08 $105.61 $116.18 $98.08
3 $14.82 $17.21
$- $-
$96.32 $100.00
$96.32 $100.00
4 $12.75
$-
$100.00
$100.00
of Fixed Income, vol. 8, no. 2 (Sept 1998) pp. 95-102
consideration of forced conversion

0.5 0.750
2 3 Value of CB if converted early
$27.00 $31.37 $20.00 $23.24 $27.00 $31.37

$134.99 $156.83
$- $-
$134.99 $156.83 $100.00 $116.18 $134.99 $156.83
$20.00 $23.24 $17.21 $20.00 $23.24
$61.94 $116.18
$43.67 $-
$105.61 $116.18 $86.07 $100.00 $116.18
$14.82 $17.21 $14.82 $17.21
$- $-
$96.32 $100.00
$96.32 $100.00 $74.08 $86.07
$12.75 $12.75
$-
$100.00
$100.00 $63.76
Binomial Option Pricing Model: Visualizing the Tree
Stock CB
S (Current share price) $20.00 T (time to CB maturity) 0.750 years
σ (sigma) p.a. 30% Face value (FcV) $100.00
Conversion Ratio (n) 5 Bond yield 15.00%
Riskfree rate 10.00% Coupon rate 0.00%
Dividend rate 0.00% Coupon frequency 4
Exercise type ("e" or "a") e European or American Call value 115%
Initial no exercise period years Put Value
No_t_steps 3
∆T 0.25 ∆T = T / Time_steps
u 1.162 u = EXP(σ*∆T^0.5)
d 0.861 d = EXP(-σ*∆T^0.5) Full Tree
p 0.5466 p = [ exp((r-q)∆T) - d ] / (u -d) Initial
Node only
Early exercise period
t 0.0000 0.2500 0.5000 0.7500 1.0000 1.2500 1.5000 1.7500 2.0000 2.2500 2.5000 2.7500 3.0000
n 0 1 2 3 4 5 6 7 8 9 10 11 12
PV of coupons added #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
S ($) #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Equity component #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Debt Component #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Total CB value #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
2 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Prepared by KURT HESS 12/02/2009 25891205.xls Convertible Bond Tree Model Page 7
Version Option Buttons (always "Node" if > 35)
TRUE Full
FALSE
3.2500 3.5000 3.7500 4.0000 4.2500 4.5000 4.7500 5.0000 5.2500 5.5000 5.7500 6.0000 6.2500 6.5000 6.7500 7.0000
13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
#VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
7.2500 7.5000 7.7500 8.0000 8.2500 8.5000 8.7500
29 30 31 32 33 34 35
#VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!

Bbands

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Theory

S0u - ending stock price in an upward move

Risk Neutral Valuation

Two-step binomial tree

S0d2 - ending stock two downward moves

u>1: Su value of stock in upward move

ck two upward moves

ock one upward/one downward moves

ock two downward moves

S (Current share price) $20.00 Tree parameters

S ($) $20.00 $23.24 $27.00 $31.37 $20.00 $23.24

consideration of forced conversion

$27.00 $31.37 $20.00 $23.24 $27.00 $31.37

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