Introduction to Binomial

Trees
Chapter 12

1 C. Hull 2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John

A Simple Binomial Model

A

stock price is currently $20

In three months it will be either $22 or $18
Stock Price = $22
Stock price = $20
Stock Price = $18

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John2C. Hull
2013

A Call Option (Figure 12.1, page 274)

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

Stock price = $20

Option Price=?
Down
Move

Stock Price = $22

Option Price = $1

Stock Price = $18

Option Price = $0

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John3C. Hull
2013

Setting Up a Riskless Portfolio

For a portfolio that is long shares and a

short 1 call option values are
Up
Move

22 1

Down
Move

18
is riskless when
22 1
= 18 or = 0.25

Portfolio

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John4C. Hull
2013

Valuing the Portfolio

(Risk-Free Rate is 12%)
The

riskless portfolio is:

long 0.25 shares
short 1
call option
The value of the portfolio in 3 months is
22 0.25 1 = 4.50
The value of the portfolio today is
4.5e 0.120.25 = 4.3670
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John5C. Hull
2013

Valuing the Option

The

portfolio that is
long 0.25 shares
short 1
option
is worth 4.367
The value of the shares is
5.000 (= 0.25 20 )
The value of the option is therefore
0.633 (= 5.000 4.367 )
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John6C. Hull
2013

Generalization (Figure 12.2, page 275)

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

Up
Move

Su
u

Down
Move

Sd
d

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John7C. Hull
2013

Generalization (continued)

Value of a portfolio that is long shares and short 1

derivative:
Up
Move

S0u u

Down
Move

S0d d
The portfolio is riskless when S0u u = S0d d or

u f d

S 0u S 0 d
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John8C. Hull
2013

Generalization
(continued)
Value

of the portfolio at time T is

Su u

Value

of the portfolio today is

(Su u )erT

Another

expression for the

portfolio value today is S f
Hence
= S
(Su u )erT
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John9C. Hull
2013

Generalization
(continued)

Substituting for we obtain

= [ pu + (1 p)d ]erT
where

e rT d
p
ud

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John10
C. Hull
2013

p as a Probability

It is natural to interpret p and 1p as the probabilities

of up and down movements
The value of a derivative is then its expected payoff in
discounted at the risk-free rate

S0

S0u
u
S0d
d

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John11
C. Hull
2013

Risk-Neutral Valuation
When the probability of an up and down
movements are p and 1-p the expected stock
price at time T is S0erT
This shows that the stock price earns the riskfree rate
Binomial trees illustrate the general result that to
value a derivative we can assume that the
expected return on the underlying asset is the
risk-free rate and discount at the risk-free rate
This is known as using risk-neutral valuation

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John12
C. Hull
2013

Irrelevance of Stocks Expected

Return
When we are valuing an option in terms of
the underlying stock the expected return
on the stock is irrelevant

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John13
C. Hull
2013

Original Example Revisited

p

(1
p)

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

0.12
Since p isearT risk-neutral
probability
20e
0.120.25
d e
0.9
0.25
p

0.6523
= 22p +u18(1

p
);
p
=
0.6523
d
1.1 0.9
Alternatively, we can use the formula

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John14
C. Hull
2013

Valuing the Option Using RiskNeutral Valuation

S

3
2
5
6
0.

Su = 22
u = 1

0.34
77

Sd = 18
The value of the option is d = 0

e0.120.25 [0.65231 + 0.34770]

= 0.633

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John15
C. Hull
2013

A Two-Step Example
Figure 12.3, page 280

24.2
22
20

19.8

Each

time step is 3 months

18
K=21, r =12%
16.2

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John16
C. Hull
2013

Valuing a Call Option

Figure 12.4, page 280
D

22
20
1.2823

2.0257
18

24.2
3.2
19.8
0.0

0.0
Value at node B
= e0.12
16.2
0.25
F
(0.65233.2 + 0.34770) = 2.0257
0.0
Value at node A
= e0.12
0.25
(0.65232.0257 + 0.34770)
= 1.2823

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John17
C. Hull
2013

A Put Option Example

Figure 12.7, page 283

50
4.1923

60
1.4147
40
9.4636

72
0
48
4
32
20

K = 52, time step =1yr

r = 5%, u =1.32, d = 0.8, p = 0.6282
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John18
C. Hull
2013

What Happens When the Put

Option is American (Figure 12.8, page 284)
72
0

60
50
5.0894
The American feature
increases the value at node
C from 9.4636 to 12.0000.

48
4

1.4147
40
12.0

This increases the value of

the option from 4.1923 to
5.0894.
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John19
C. Hull
2013

32
20

Delta
Delta

() is the ratio of the change

in the price of a stock option to the
change in the price of the
underlying stock
The value of varies from node to
node

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John20
C. Hull
2013

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

d 1 u e

where is the volatility andt is the length

of the time step. This is the approach used
by Cox, Ross, and Rubinstein (1979)
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John21
C. Hull
2013

Assets Other than Non-Dividend

Paying Stocks
For

options on stock indices, currencies

and futures the basic procedure for
constructing the tree is the same except
for the calculation of p

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John22
C. Hull
2013

The Probability of an Up Move

p

ad
ud

a e rt for a nondividen d paying stock

a e ( r q ) t for a stock index wher e q is the dividend
yield on the index
( r r ) t

ae f
for a currency where r f is the foreign
risk - free rate
a 1 for a futures contract
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John23
C. Hull
2013

Increasing the Time Steps

In

practice at least 30 time steps are

necessary to give good option values
DerivaGem allows up to 500 time steps to
be used

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John24
C. Hull
2013

The Black-Scholes-Merton Model

The

BSM model can be derived by looking

at what happens to the price of a
European call option as the time step
tends to zero
See Appendix to Chapter 12

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John25
C. Hull
2013