Binomial option pricing model

The binomial option-pricing model is a tool to price the options. The price of an option is
commonly referred to as option premium.

Intuitive Background for developing Binomial option pricing model

Consider the following data on a European call option on stock

1. Time to expiry – 1 month

2. Current stock price (ST-1) is Rs 40
3. Expected stock price on expiration date (if price moves up) ST,u is Rs 50
4. Expected stock price on expiration date (if price goes down) ST,d is Rs 35
5. Strike price of call option – Rs 45

If the stock rises to Rs 50 on the expiration date, then the call option would be worth Rs 5
because for a European option (exercisable only on expiration date) the call is worth only
its intrinsic value i.e. Maximum of {(Market price minus strike price), 0}.

On the other hand, if the stock falls to Rs 35 on the expiration date, then the call option
would expire worthless – Rs 0 i.e. Maximum of {(Market price minus strike price), 0}
being Maximum of {(Rs35 minus Rs45), 0}

Assume that the investor has created a levered portfolio that duplicates the payoffs of
the call option. The rate of interest is 1% p.m. The levered portfolio consists of 1/3 rd of
share and Rs 11.551155 in borrowed funds. The levered portfolio should yield the same
returns as that of call option since it duplicates the payoffs associated with the call option.

Accordingly if the stock price moves up, the cash flows of levered portfolio would be
thus
1/3rd of stock price – repayment of borrowed funds with interest
50*(0.333) – 11.551155*(1.01)
16.6665 – 11.6665
Rs 5

On the other hand, if the stock price goes down, the cash flows of levered portfolio would
be thus
1/3rd of stock price – repayment of borrowed funds with interest
35*(0.333) – 11.551155*(1.01)
11.6665 – 11.6665
Rs 0

Since the call offers exactly the same payoffs (at time T) as the levered portfolio, it
follows that the initial investment in both the cases must also be same. The investment in
the case of a call option is the option premium or option price paid by the call holder
upfront to the call writer. Thus the option premium can be computed by ascertaining the
initial investment made in the levered portfolio as

1/3rd of stock price – Borrowed funds

40*(0.333) – 11.551155
13.3332 – 11.551155
Rs 1.782

The option premium of Rs 1.782 should hold good because deviations from this represent
arbitrage opportunities by exploiting which the price would rest @ Rs 1.782. This is
captured in the table below

Call option Overvalued in relation to Levered Portfolio

Strategy: Sell call and Buy levered portfolio

All figures are in Rs

Action at Time T-1 Cash flows at T-1 Cash flows Cash flows
ST is Rs 35 ST is Rs 50

Sell call +2 0 -5
Buy 1/3rd share of stock - 13.333333 +11.66667 +16.66667
Borrow + 11.551155 - 11.66667 - 11.66667
+ 0.217822 0 0

Call option undervalued in relation to Levered Portfolio

Strategy: Buy call and Sell levered portfolio

All figures are in Rs

Action at Time T-1 Cash flows at T-1 Cash flows Cash flows
ST is Rs 35 ST is Rs 50

Buy call -1.50 0 +5

Sell 1/3rd share of stock + 13.333333 - 11.66667 - 16.66667
Lend - 11.551155 + 11.66667 + 11.66667
+ 0.282178 0 0

Assumptions in deriving the Binomial option-pricing model

1. Investors prefer more wealth to less wealth.

2. Markets are perfect and competitive i.e. no transaction costs, no margin
requirements, no taxes.
3. Investors can use proceeds from short sale.
4. Investors can trade fractions of securities.
5. Only one interest rate, r and investors can risklessly borrow and lend at that rate.
6. The periodic interest rate (r), sizes of the uptick (u) and downtick (d) are
deterministic for every future period and the stock can move only according to
 this “Geometric random walk” However u, d, r need not be constant in case of
multi period model.

The following steps may be adopted in arriving at the option price using binomial option
pricing model

1. Define the stock price process

The stock price can either go up or come down from its T-1 price (Today’s price).
It is necessary to assign the values for u and d i.e. as a percentage of the stock’s
current price.

ST, u = (1+u) ST-1

ST-1
ST, d = (1+d) ST-1

The parameters u and d are the possible rates of return on the underlying asset. In
case of some of the financial assets viz. Treasury bills the value of d may be
greater than zero. However it is important to understand that the relationship
among u, d and r is as follows i.e.

U>R>D

The above relationship should hold good because if U > D > R, then it means that
people can borrow at the risk less rate and make profit even if the stock multiplies
by (1+d). Similarly if R > U >D, then it implies that people can invest in the risk
less asset and enjoy much better returns than investing in the risky asset.
2. Determine the terminal prices of a call option

The call price on expiration would be equal to its intrinsic value and hence the
call price can be either of the two

CT, u = Max (0,ST,u – K)

CT-1
CT, d = Max (0,ST,d – K)

Where K is the strike price of the option.

3. Equate the payoffs of an unknown “equivalent portfolio” with the payoffs of

the call

In the above example we knew of the equivalent portfolio as 1/3rd of stock and
Rs11.551155 of borrowed funds. In the binomial option-pricing model the above
values have to be solved.

Consider as the fraction of the share and Rs B as borrowed funds

 Note that will always be positive or zero and B will always be negative or
zero. This implies that a call is equivalent to a portfolio of consisting of a long
position in stock and borrowing. In a put option will always be negative or
zero and B will always be positive or zero. This implies that a put is equivalent to
a portfolio of consisting of a short position in stock and lending.

ST,u + (1+r)B

ST-1 + B
ST,d + (1+r)B

Equating the payoffs of call prices and the pay offs of the levered portfolio we
have,

ST,u + (1+r)B = CT,u

ST,d + (1+r)B = CT,d

Solving the above equations we get the values for and B as follows

CT,u - CT,d
=
ST,u - ST,d

(1+u)CT,d - (1+d)CT,u
B=
(u-d) (1+r)

The value of signifies the fraction of one share of stock to buy in order to
replicate one call. The above value will lie between 0 and 1. In our example it was
1/3rd of share i.e. 0.33. The value of B specifies how much to borrow to finance
the investment in the stock. In our example it was Rs 11.551155.

4. Determine the call price

The call price is determined as follows

CT-1 = ST-1 + B