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M. Haugh
G. Iyengar
114.49
PP
P
PP107
107
PPP
100
PP
100
PP
PP
PP 93.46
PP93.46
P
P
PP
PP87.34
P
PP
PP 81.63
P
t=0
t=1
t=2
t=3
22.5
122.50
?
114.49
PP
7
PP 107
107
P
PP
PP 100
P
0
PP
PP
PP 93.46
PP93.46
P
PP
PP 87.34
PP
0
PP
PP 81.63
P
t=0
t=1
t=2
t=3
100
15.48
114.49
7
P
10.23
PP 107
107
P
P
3.86
6.57
PPP 100
100
P
0
PP 2.13 P
P
PPP
P93.46
93.46
PP
0
PP 87.34
PP 0
PP 81.63
P
t=0
t=1
t=2
P
t=3
Q
q3
3q 2 (1 q)
3q(1 q)2
(1 q)3
1 Q
E [max(ST 100, 0)]
R3 0
(1)
M. Haugh
G. Iyengar
a 110
p = .99
S0 = 100
a hh
h
hhhh
hha 90
1 p = .01
t=0
Stock XYZ
t=1
a 110
p = .01
S0 = 100
ahh
hh
hhhh
ha
1 p = .99
t=0
90
t=1
Question: What is the price of a call option on ABC with strike K = $100?
Question: What is the price of a call option on XYZ with strike K = $100?
2
=
=
=
1 Rd
uR
Cu +
Cd
R ud
ud
1
[qCu + (1 q)Cd ]
R
1 Q
E [C1 ]
R 0
100.00
t=0
106.00
94.34
t=1
112.36
100.00
89.00
119.10
106.00
94.34
83.96
11.04
t=2
t=3
t=0
14.76
4.56
19.22
7.08
0.00
24.10
11.00
0.00
0.00
t=1
t=2
t=3
R = 1.04
Stock Price
100.00
t=0
106.00
94.34
t=1
112.36
100.00
89.00
119.10
106.00
94.34
83.96
15.64
t=2
t=3
t=0
18.19
6.98
21.01
8.76
0.00
24.10
11.00
0.00
0.00
t=1
t=2
t=3
1 Q
E [CT ]
Rn 0
(2)
M. Haugh
G. Iyengar
PPP 0
107
P
P
P
PP 100
100
PP
6.54
PP
PP
PP
93.46
93.46
PP
P
P
PP 87.34
P
18.37
PP
PP
81.63
P
t=0
t=1
t=2
t=3
107
0
114.49
PP
0
1.26
PP 107
107
P
P
2.87
PPP
3.82
PP100
100
P
7.13
PP
6.54
PP 93.46 PPP 93.46
PP
PP
12.66
PP
PP 87.34
P
PP
PP 18.37
81.63
PP
t=0
t=1
t=2
t=3
Question: If you are risk-neutral, how much would you pay to play this game?
Solution: Work backwards, starting with last possible throw:
1. You have just 1 throw left so fair value is 3.5.
2. You have 2 throws left so must figure out a strategy determining what to do
after 1st throw. We find
fair value = 16 (4 + 5 + 6) + 12 3.5 = 4.25.
3. Suppose you are allowed 3 throws. Then ...
Question: What if you could throw the die 1000 times?
4
M. Haugh
G. Iyengar
u 3 S0
2P
u
S0 P P
PP
P
P
uS0
uS0 PPP
P
P
P
P
S0 PP
S0 PPP
PP
PP
P
P
dS0
dS0 PP
PP
P
P
d 2 S0 P P P
PP 3
d S0
t=0
t=1
t=2
t=3
x1 S0 + y1 B0 for t = 0
Vt =
xt St + yt Bt
for t 1.
(3)
(x1 S1 + y1 B1 ) (x1 S0 + y1 B0 )
= x1 (S1 S0 ) + y1 (B1 B0 ).
The initial cost of this replicating strategy must equal the value of the
option
- otherwise theres an arbitrage opportunity.
The dynamic replication price is of course equal to the price obtained from
using the risk-neutral probabilities and working backwards in the lattice.
And at any node, the value of the option is equal to the value of the
replicating portfolio at that node.
22.5
122.50
[1, 97.06]
15.48
114.49
PP
PP
7
10.23
PP 107
107
P
PPP [.52, 46.89]
PP 3.86
6.57
100
PP
100
PP
PP
PP
PP
2.13
0
PP 93.46
PP93.46
P
P
PP
PP
0
PP 87.34
P
P
[0, 0] PPP
PP 0
P81.63
t=0
t=1
t=2
t=3
22.5
122.50
[1, 97.06]
15.48
114.49
[.802, 74.84]
PP
PP
7
10.23
PP 107
107
P
PPP [.517, 46.89]
[.598, 53.25]
PP 3.86
6.57
100
PP
100
PP
PP
PP
PP
2.13
0
PP 93.46
PP93.46
P
P
PP
[.305, 26.11]
PP
0
PP 87.34
P
P
[0, 0] PPP
PP 0
P81.63
t=0
t=1
t=2
t=3
M. Haugh
G. Iyengar
Including Dividends
C1 (S1 )
S0
a
h
hh
a
uS0 + cS0 Cu
p
hhhh
1p
t=0
hhha
dS0 + cS0 Cd
t=1
Cu
dS0 x + cS0 x + Ry
Cd
2
=
=
=
1 Rd c
u+cR
Cu +
Cd
R
ud
ud
1
[qCu + (1 q)Cd ]
R
1 Q
E [C1 ].
R 0
(5)
(6)
i=1
P i + E0
Rn
n
X
i=1
Pi +
EQ
0
Sn
Rn
which is (7).
M. Haugh
G. Iyengar
u 2 S0
PP
PP uS0
uS0
P
PP
P
S
0
PP
S0
PP
PP
PP dS0
PP dS0
P
PP
PP 2
0
PdPS
PP
P P d 3 S0
P
t=0
t=1
t=2
t=3
Consider now a forward contract on the stock that expires after n periods.
Let G0 denote date t = 0 price of the contract.
Recall G0 is chosen so that contract is initially worth zero.
2
EQ
0
Sn G0
Rn
so that
G0 = EQ
0 [Sn ] .
(8)
Again, (8) holds whether the underlying security pays dividends or not.
This is false!
A futures contract always costs nothing.
The price, Ft is only used to determine the cash-flow associated with
holding the contract
- so that (Ft Ft1 ) is the payoff received at time t from a long or short
position of one contract held between t 1 and t.
EQ
k [Ft+1 ]
=
..
.
Q
EQ
t [Et+1 [Ft+2 ]]
..
.
Q
Q
EQ
t [Et+1 [ En1 [Fn ]]].
(9)
Note that (9) holds whether the security pays dividends or not
- dividends only enter through Q.
Comparing (8) and (9) and we see that F0 = G0 in the binomial model
- not true in general.
M. Haugh
G. Iyengar
/2)t+Wt
d2
log(S0 /K ) + (r c + 2 /2)T
,
T
d1 T
/2)t+Wt
T
n
4. dn = 1/un
and now price European and American options, futures etc. as before.
Then risk-neutral probabilities calculated as
T
qn =
e (rc) n dn
.
un dn
1 Q
E [max(ST K , 0)]
Rn 0
(10)
1
Rnn
n
j
j=0
n
S0 X
Rnn
n
j
j=
n
K X
Rnn
n
j
qnj (1 qn )nj
j=
Some History
Bachelier (1900) perhaps first to model Brownian motion
- modeled stock prices on the Paris Bourse
- predated Einstein by 5 years.
M. Haugh
G. Iyengar
for 0 t < n.