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# Derivative Securities

Chapter 10

## A Simple Binomial Model

A stock price is currently \$20 In three months it will be either \$22 or \$18

## Stock price = \$20

Stock Price = \$18

## A Call Option (Figure 11.1, page 248)

A 3-month call option on the stock has a strike price of 21.

## Stock Price = \$22 Option Price = \$1

Stock price = \$20 Option Price=?

22 1

or

## Valuing the Portfolio (Risk-Free Rate is 12%)

The riskless portfolio is: long 0.25 shares short 1 call option

## Generalization (Figure 11.2, page 249)

A derivative lasts for time T and is dependent on a stock

Su u

Sd d
FIN 480 (Instructor- Saif Rahman)

Generalization (continued)

Su u

Sd d

## The portfolio is riskless when Su u = Sd

d or

u Su
6

fd Sd
FIN 480 (Instructor- Saif Rahman)

Generalization (continued)

Su

(Su

u )erT

## FIN 480 (Instructor- Saif Rahman)

Generalization (continued)

Substituting for

we obtain

= [ p u + (1 p )d ]erT

where

e u

rT

d d
FIN 480 (Instructor- Saif Rahman)

Risk-Neutral Valuation

= [ p u + (1 p )d ]e-rT The variables p and (1 p ) can be interpreted as the risk-neutral probabilities of up and down movements The value of a derivative is its expected payoff in a risk-neutral world discounted at the risk-free rate

S
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Su u
Sd d
FIN 480 (Instructor- Saif Rahman)

## Original Example Revisited

Su = 22 u = 1 S Sd = 18 d = 0

Since p is a risk-neutral probability -20e0.12 0.25 = 22p + 18(1 p ); p = 0.6523 Alternatively, we can use the formula

e rT d u d

0.6523

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## Valuing the Option

Su = 22 u = 1 S
The value of the option is e0.12 0.25 [0.6523 1 + 0.3477 0] = 0.633

Sd = 18 d = 0

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## Valuing a Call Option

Figure 11.4, page 253
D

22

24.2 3.2

B E

20 1.2823

2.0257 18
C

## 19.8 0.0 16.2 0.0

0.0

Value at node B = e0.12 0.25(0.6523 3.2 + 0.3477 0) = 2.0257 Value at node A = e0.12 0.25(0.6523 2.0257 + 0.3477 0) = 1.2823

## Each time step is 3 months K=21, r=12%

FIN 480 (Instructor- Saif Rahman)

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## A Put Option Example; K=52

Figure 11.7, page 256

K = 52, t = 1yr r = 5%
60
50 4.1923
A

72 0

B
E

1.4147 40
C

48 4 32 20

9.4636
F

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## What Happens When an Option is American

(Figure 11.8, page 257)
72 0
48 4 32 20

60
50 5.0894
A

B E

1.4147 40
C

12.0
F

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## FIN 480 (Instructor- Saif Rahman)

Delta

= Delta = Change in price of the option/Change in price of the stock = Number of units of the stock that are held for each call option shorted to create a risk free hedge

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The value of

## varies from node to node

FIN 480 (Instructor- Saif Rahman)

Choosing u and d
One way of matching the volatility is to set
u d e 1 u
t

where is the volatility and t is the length of the time step. This is the approach used by Cox, Ross, and Rubinstein

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## The Probability of an Up Move

a d p u d a e r t for a nondividen d paying stock a a e(r e
q) t

for a stock index wher e q is the dividend for a currency where r f is the foreign

(r rf ) t

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