Introduction to Binomial Trees

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CHAPTER 12
Introduction to Binomial Trees
Practice Questions
Problem 12.8.
Consider the situation in which stock price movements during the life of a European option are governed by a two-step binomial tree. Explain why it is not possible to set up a position in the stock and the option that remains riskless for the whole of the life of the option.The riskless portfolio consists of a short position in the option and a long position in shares. Because changes during the life of the option, this riskless portfolio must also change.
Problem 12.9.
A stock price is currently $50. It is known that at the end of two months it will be either $53 or $48. The risk-free interest rate is 10% per annum with continuous compounding. What is the value of a two-month European call option with a strikeprice of $49? Use no-arbitrage arguments.At the end of two months the value of the option will be either $4 (if the stock price is $53) or $0 (if the stock price is $48). Consider a portfolio consisting of:
The value of the portfolio is either or in two months. If
i.e.,
the value of the portfolio is certain to be 38.4. For this value of the portfolio is therefore riskless. The current value of the portfolio is:
where is the value of the option. Since the portfolio must earn the risk-free rate of interest
i.e.,
The value of the option is therefore $2.23.
This can also be calculated directly from equations (12.2) and (12.3). , so that
and
Problem 12.10.
A stock price is currently $80. It is known that at the end of four months it will be either $75 or $85. The risk-free interest rate is 5% per annum with continuous compounding. What is the value of a four-month European put option with a strikeprice of $80? Use no-arbitrage arguments.At the end of four months the value of the option will be either $5 (if the stock price is $75) or $0 (if the stock price is $85). Consider a portfolio consisting of:
(Note: The delta, of a put option is negative. We have constructed the portfolio so that it is +1 option and shares rather than option and shares so that the initial investment is positive.)
The value of the portfolio is either or in four months. If
i.e.,
the value of the portfolio is certain to be 42.5. For this value of the portfolio is therefore riskless. The current value of the portfolio is:
where is the value of the option. Since the portfolio is riskless
i.e.,
The value of the option is therefore $1.80.
This can also be calculated directly from equations (12.2) and (12.3). , so that
and
Problem 12.11.
A stock price is currently $40. It is known that at the end of three months it will be either $45 or $35. The risk-free rate of interest with quarterly compounding is 8% per annum. Calculate the value of a three-month European put option on the stock with an exercise price of $40. Verify that no-arbitrage arguments and risk-neutral valuation arguments give the same answers.At the end of three months the value of the option is either $5 (if the stock price is $35) or $0 (if the stock price is $45).
Consider a portfolio consisting of:
(Note: The delta, , of a put option is negative. We have constructed the portfolio so that it is +1 option and shares rather than option and shares so that the initial investment is positive.)
The value of the portfolio is either or . If:
i.e.,
the value of the portfolio is certain to be 22.5. For this value of the portfolio is therefore riskless. The current value of the portfolio is
where f is the value of the option. Since the portfolio must earn the risk-free rate of interest
Hence
i.e., the value of the option is $2.06.
This can also be calculated using risk-neutral valuation. Suppose that is the probability of an upward stock price movement in a risk-neutral world. We must have
i.e.,
or:
The expected value of the option in a risk-neutral world is:
This has a present value of
This is consistent with the no-arbitrage answer.
Problem 12.12.
A stock price is currently $50. Over each of the next two three-month periods it is expected to go up by 6% or down by 5%. The risk-free interest rate is 5% per annum with continuous compounding. What is the value of a six-month European call option with a strike price of $51?A tree describing the behavior of the stock price is shown in Figure S12.1. The risk-neutral probability of an up move, p, is given by
There is a payoff from the option of for the highest final node (which corresponds to two up moves) zero in all other cases. The value of the option is therefore
This can also be calculated by working back through the tree as indicated in Figure S12.1. The value of the call option is the lower number at each node in the figure.
Figure S12.1 Tree for Problem 12.12
Problem 12.13.
For the situation considered in Problem 12.12, what is the value of a six-month European put option with a strike price of $51? Verify that the European call and European put prices satisfy put–call parity. If the put option were American, would it ever be optimal to exercise it early at any of the nodes on the tree?The tree for valuing the put option is shown in Figure S12.2. We get a payoff of if the middle final node is reached and a payoff of if the lowest final node is reached. The value of the option is therefore
This can also be calculated by working back through the tree as indicated in Figure S12.2.
The value of the put plus the stock price is from Problem 12.12
The value of the call plus the present value of the strike price is
This verifies that put–call parity holds
To test whether it worth exercising the option early we compare the value calculated for the option at each node with the payoff from immediate exercise. At node C the payoff from immediate exercise is . Because this is greater than 2.8664, the option should be exercised at this node. The option should not be exercised at either node A or node B.
Figure S12.2 Tree for Problem 12.13
Problem 12.14.
A stock price is currently $25. It is known that at the end of two months it will be either $23 or $27. The risk-free interest rate is 10% per annum with continuous compounding. Suppose is the stock price at the end of two months. What is the value of a derivative that pays off at this time?At the end of two months the value of the derivative will be either 529 (if the stock price is 23) or 729 (if the stock price is 27). Consider a portfolio consisting of:
The value of the portfolio is either or in two months. If
i.e.,
the value of the portfolio is certain to be 621. For this value of the portfolio is therefore riskless. The current value of the portfolio is:
where is the value of the derivative. Since the portfolio must earn the risk-free rate of interest
i.e.,
The value of the option is therefore $639.3.
This can also be calculated directly from equations (12.2) and (12.3). , so that
and
Problem 12.15.
Calculate , , and when a binomial tree is constructed to value an option on a foreign currency. The tree step size is one month, the domestic interest rate is 5% per annum, the foreign interest rate is 8% per annum, and the volatility is 12% per annum.In this case
Problem 12.16.
The volatility of a non-dividend-paying stock whose price is $78, is 30%. The risk-free
rate is 3% per annum (continuously compounded) for all maturities. Calculate values for
u, d, and p when a two-month time step is used. What is the value of a four-month
European call option with a strike price of $80 given by a two-step binomial tree.
Suppose a trader sells 1,000 options (10 contracts). What position in the stock is
necessary to hedge the trader’s position at the time of the trade?
The tree is given in Figure S12.3. The value of the option is $4.67. The initial delta is 9.58/(88.16 – 69.01) which is almost exactly 0.5 so that 500 shares should be purchased.
Figure S12.3: Tree for Problem 12.16
Problem 12.17.
A stock index is currently 1,500. Its volatility is 18%. The risk-free rate is 4% per annum
(continuously compounded) for all maturities and the dividend yield on the index is
2.5%. Calculate values for u, d, and p when a six-month time step is used. What is the
value a 12-month American put option with a strike price of 1,480 given by a two-step
binomial tree.
The tree is shown in Figure S12.4. The option is exercised at the lower node at the six-month point. It is worth 78.41.
Figure S12.4: Tree for Problem 12.17
Problem 12.18
The futures price of a commodity is $90. Use a three-step tree to value (a) a nine-month
American call option with strike price $93 and (b) a nine-month American put option
with strike price $93. The volatility is 28% and the risk-free rate (all maturities) is 3%
with continuous compounding.
The tree for valuing the call is in Figure S12.5a and that for valuing the put is in Figure S12.5b. The values are 7.94 and 10.88, respectively.
Figure S12.5a: Call Figure S12.5b: Put
Further Questions
Problem 12.19
The current price of a non-dividend-paying biotech stock is $140 with a volatility of
25%. The risk-free rate is 4%. For a three-month time step:
(a) What is the percentage up movement?
(b) What is the percentage down movement?
(c) What is the probability of an up movement in a risk-neutral world?
(d) What is the probability of a down movement in a risk-neutral world?
Use a two-step tree to value a six-month European call option and a six-month
European put option. In both cases the strike price is $150.
= 1.1331. The percentage up movement is 13.31%
d = 1/u = 0.8825. The percentage down movement is 11.75%
The probability of an up movement is
The probability of a down movement is0.4911.
The tree for valuing the call is in Figure S12.6a and that for valuing the put is in Figure S12.6b. The values are 7.56 and 14.58, respectively.
Figure S12.6a: Call Figure S12.6b: Put
Problem 12.20
In Problem 12.19, suppose that a trader sells 10,000 European call options and a two-step binomial tree describes the behavior of the stock. How many shares of the stock are needed to hedge the position for the first and second three-month period? For the second time period, consider both the case where the stock price moves up during the first period and the case where it moves down during the first period.
The delta for the first period is 15/(158.64 – 123.55) = 0.4273. The trader should take a long position in 4,273 shares. If there is an up movement the delta for the second period is 29.76/(179.76 – 140) = 0.7485. The trader should increase the holding to 7,485 shares. If there is a down movement the trader should decrease the holding to zero.
Problem 12.21.
A stock price is currently $50. It is known that at the end of six months it will be either $60 or $42. The risk-free rate of interest with continuous compounding is 12% per annum. Calculate the value of a six-month European call option on the stock with an exercise price of $48. Verify that no-arbitrage arguments and risk-neutral valuation arguments give the same answers.At the end of six months the value of the option will be either $12 (if the stock price is $60) or $0 (if the stock price is $42). Consider a portfolio consisting of:
The value of the portfolio is either or in six months. If
i.e.,
the value of the portfolio is certain to be 28. For this value of the portfolio is therefore riskless. The current value of the portfolio is:
where is the value of the option. Since the portfolio must earn the risk-free rate of interest
i.e.,
The value of the option is therefore $6.96.
This can also be calculated using risk-neutral valuation. Suppose that is the probability of an upward stock price movement in a risk-neutral world. We must have
i.e.,
or:
The expected value of the option in a risk-neutral world is:
This has a present value of
Hence the above answer is consistent with risk-neutral valuation.
Problem 12.22.
A stock price is currently $40. Over each of the next two three-month periods it is expected to go up by 10% or down by 10%. The risk-free interest rate is 12% per annum with continuous compounding.
What is the value of a six-month European put option with a strike price of $42?
What is the value of a six-month American put option with a strike price of $42?
A tree describing the behavior of the stock price is shown in Figure S12.7. The risk-neutral probability of an up move, , is given by
Calculating the expected payoff and discounting, we obtain the value of the option as
The value of the European option is 2.118. This can also be calculated by working back through the tree as shown in Figure S12.7. The second number at each node is the value of the European option.
The value of the American option is shown as the third number at each node on the tree. It is 2.537. This is greater than the value of the European option because it is optimal to exercise early at node C.
Figure S12.7 Tree to evaluate European and American put options in Problem 12.22. At each node, upper number is the stock price, the next number is the European put price, and the final number is the American put price
Problem 12.23.
Using a “trial-and-error” approach, estimate how high the strike price has to be in Problem 12.22 for it to be optimal to exercise the option immediately.
Trial and error shows that immediate early exercise is optimal when the strike price is above 43.2.
This can be also shown to be true algebraically. Suppose the strike price increases by a relatively small amount . This increases the value of being at node C by and the value of being at node B by . It therefore increases the value of being at node A by
For early exercise at node A we require or . This corresponds to the strike price being greater than 43.196.
Problem 12.24.
A stock price is currently $30. During each two-month period for the next four months it is expected to increase by 8% or reduce by 10%. The risk-free interest rate is 5%. Use a two-step tree to calculate the value of a derivative that pays off where is the stock price in four months? If the derivative is American-style, should it be exercised early?
This type of option is known as a power option. A tree describing the behavior of the stock price is shown in Figure S12.8. The risk-neutral probability of an up move, , is given by
Calculating the expected payoff and discounting, we obtain the value of the option as
The value of the European option is 5.394. This can also be calculated by working back through the tree as shown in Figure S12.8. The second number at each node is the value of the European option.
Early exercise at node C would give 9.0 which is less than 13.2449. The option should therefore not be exercised early if it is American.
Figure S12.8 Tree to evaluate European power option in Problem 12.24. At each node, upper number is the stock price and the next number is the option price
Problem 12.25.
Consider a European call option on a non-dividend-paying stock where the stock price is $40, the strike price is $40, the risk-free rate is 4% per annum, the volatility is 30% per annum, and the time to maturity is six months.
Calculate , , and for a two step tree
Value the option using a two step tree.
Verify that DerivaGem gives the same answer
Use DerivaGem to value the option with 5, 50, 100, and 500 time steps.
(a) In this case so that , , and
(b) and (c) The value of the option using a two-step tree as given by DerivaGem is shown in Figure S12.9 to be 3.3739. To use DerivaGem choose the first worksheet, select Equity as the underlying type, and select Binomial European as the Option Type. After carrying out the calculations select Display Tree.
(d) With 5, 50, 100, and 500 time steps the value of the option is 3.9229, 3.7394, 3.7478, and 3.7545, respectively.
Figure S12.9 Tree produced by DerivaGem to evaluate European option in Problem 12.25
Problem 12.26.
Repeat Problem 12.25 for an American put option on a futures contract. The strike price and the futures price are $50, the risk-free rate is 10%, the time to maturity is six months, and the volatility is 40% per annum.
(a) In this case and , , and
(b) and (c) The value of the option using a two-step tree is 4.8604.
(d) With 5, 50, 100, and 500 time steps the value of the option is 5.6858, 5.3869, 5.3981, and 5.4072, respectively.
Problem 12.27
A stock index is currently 990, the risk-free rate is 5%, and the dividend yield on the
index is 2%. Use a three-step tree to value an 18-month American put option with a
strike price of 1,000 when the volatility is 20% per annum. How much does the option
holder gain by being able to exercise early? When is the gain made?
The tree is shown in Figure S12.10. The value of the option is 87.51. It is optimal to exercise at the lowest node at time one year. If early exercise were not possible the value at this node would be 236.63. The gain made at the one year point is therefore 253.90 – 236.63
= 17.27.
Figure S12.10 Tree for Problem 12.27
Problem 12.28
Calculate the value of nine-month American call option on a foreign currency using a
three-step binomial tree. The current exchange rate is 0.79 and the strike price is 0.80
(both expressed as dollars per unit of the foreign currency). The volatility of the
exchange rate is 12% per annum. The domestic and foreign risk-free rates are 2%
and 5%, respectively. Suppose a company has bought options on 1 million units of the
foreign currency. What position in the foreign currency is initially necessary to hedge its
risk?
The tree is shown in Figure S12.11. The cost of an American option to buy one million units of the foreign currency is $18,100. The delta initially is (0.0346 −0.0051)/(0.8261 – 0.7554) = 0.4176. The company should sell 417,600 units of the foreign currency
Figure S12.11: Tree for Problem 12.28

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