Numerical Procedures movement) and Sd (a down movement), where u > 1,
(Hull Ch. 20, 8th Ed.) and d < 1.
Review of Chapter 12
We now want to review the results of Chapter 12 for a
binomial tree of arbitrary size. We assume that at each
step of the tree, the stock price moves from its initial
value of S to one of two new values, Su (an up
20-1
the number of steps you use need not have anything to
do with the time to maturity; for example, you may use a
5-step tree to price a 3-month option, or whatever.
Naturally, the more steps you use, the more accurate
your estimate of the options price.
Determination of p, u, and d
Note that in this section we assume that S is the price of a
non-dividend paying stock. There are two conditions
that the parameters, p, u, and d must satisfy. First, we
require that the stocks expected return (as calculated by
20-3
We also assume that the risk-free rate, r, is constant, as well
as the parameters p, u, and d. Once we determine these
parameters, we find the value of the derivative by
calculating the payoffs at maturity, and then working
backward through the tree using risk-neutral valuation.
The parameters we choose will depend on the size of the
time step, t. If we use an n-step binomial tree, and the
option matures at time T, then t = T/n. Note also that
20-2
the binomial model) be equal to the risk-free rate.
Second, we require that the stocks volatility (as
calculated by the binomial model) be equal to the
stocks observed volatility. The stocks volatility is
defined to be the standard deviation of the stocks
continuously compounded returns.
The first condition can be written as
Ep[St+t] = Stert.
As we saw earlier, this becomes
Ep[St+t] = pSu + (1 p)Sd = Sert,
20-4
 e rt d ways to proceed. One, is to add the condition (i) d = 1/u.
which implies that p = , as usual.
ud The second is to assume that (ii) p = 12 .
One way of specifying the second condition is to require
Case (i): d = 1/u. We must find u and d such that
that (see Ch. 13) S t + t
Varp(ln ) = 2t.
S t + t St
Varp(ln ) = 2t.
St t t
It turns out that u = e , d = e .
Here, is the stocks volatility.
ASIDE: here is a derivation of the result, for those who are
Now, there are two equations, but three unknowns, p, u, and
interested. Now, for any random variable, Y say, the
d. So, we have some flexibility. There are two common
variance is given by Var(Y) = E[Y2] (E[Y])2.
We saw (in Chapter 13) that under risk-neutrality

20-5 20-6

S t + t = p[ln(u)]2 + (1 p)[ln(d)]2 [(r 12 2)t]2

Ep[ln( )] = (r 12 2)t.
St
= [ln(u)]2 [(r 12 2)t]2
Thus,
[ln(u)]2,
S Su Sd
Varp(ln t + t ) = p(ln )2 + (1 p)(ln )2 [(r 12 2)t]2 since [(r 12 2)t]2 is small. It follows that we want
St S S
t
Su Sd [ln(u)]2 = 2t, or u = e .
Now, ln = ln(u), and since d = 1/u, ln = ln(d) = ln(u).
S S This ends the derivation.
So, NOTE: If we want the exact value for u, we can write
S t + t 2t = [ln(u)]2 [(r 12 2)t]2,
Var(ln ) = 2t
St
or [ln(u)]2 = 2t + [(r 12 2)t]2,

20-7 20-8
 which gives S t + t
then, p 12 , and Var(ln ) = 2t.
St
u = exp 2 t + (r 12 2 ) 2 (t ) 2 .

NOTE: Hull uses Case (i), d = 1/u, exclusively, so we will

t
CONCLUSION: if we assume that d = 1/u, then u = e ,
do the same.
rt
t e d
d = e , and p = . CONCLUSIONS: The parameters we choose will depend on
ud
the size of the time step, t. If we use an n-step
Case (ii): p = 12 . [See section 20.4, pp. 442-445 in Hull.]
binomial tree, and the option matures at time T, then t
If we let
t
( r 1 2 ) t + t ( r 1 2 ) t t
= T/n. If we assume that d = 1/u, then u = e ,
u=e 2
and d = e 2
,

20-9 20-10

t e rt d Note that, throughout this chapter, we assume that

d = e , and p = (for a non-dividend paying
ud 1
d = . In particular, note that Sud = S.
stock). u
Note also that this tree recombines (i.e., up then down
Expressing the Approach Algebraically leads to the same price as down then up.) With a
Recall our notation that at time zero, the stock price is S. At non-recombining tree, at time it, there are 2i possible
time t, the price can be either Su or Sd; at time 2t, prices; thus the tree grows too large too quickly.
there are three possible prices, Suu, Sud = S, or Sdd. In ASIDE: Lets see how big Excel is.
general, at time it, there are i + 1 possible stock prices: Rows: Old version: 216 = 65,536 rows,

Su jd i j, where j = 0, 1,, i. New version: 220 = 1,048,576 rows;

20-11 20-12
 Columns: Old version: 28 = 256 columns, 20.1 BINOMIAL TREES (contd)
New version: 214 = 16,348 columns. Estimating Delta and Other Hedge Parameters
We can now simplify the notation for the option price at a Recall that Delta is given by
given node in the tree. Weve been using f u, f d, f uu, etc. f f
Delta := = ,
S S
for the option price at different nodes. Lets define fi, j to
where S is a small change in the stock price and f is
be the option price at date it when the stock has gone
the corresponding small change in the option price
up j times. So, for example, f uuud = f4,3 and f uddd = f4,1.
(while all other variables are assumed to remain
constant). We can estimate Delta from the binomial
tree. Why would we want to estimate Delta or the other

20-13 20-14

hedge parameters from a binomial tree when we have Heres a two-step tree:
the analytic formulas based on Black-Scholes? Su2
f22
Su
Keep in mind that we are using Taylors theorem, which S f11 S
f f21
says that small changes in the option price, f, can be
Sd
approximated by f10 Sd2
f20
f 1 2 f f f f t=0 t 2t
f S + 2
(S ) 2 + t + r + + .
S 2 S t r
Note that d = 1/u implies that Sud = S. At step 1 in the tree,
we have an estimate, f11, for the option price when the

20-15 20-16
 stock price is Su, and an estimate, f10, for the option Other Greek Letters
price when the stock price is Sd. In other words, when We can estimate some of the other hedge parameters as
S = Su Sd, the value of f is f11 f10. So, an estimate well. In continuous time, Gamma, , is the second
for at t = 0 is derivative of the option price with respect to S:
f 11 f 10 f 2 f
Delta = = . (20.8) Gamma = = =
Su Sd S S 2 S
This is just the same delta used for our arbitrage arguments To estimate Gamma, , we need to find the derivative of
from Ch. 12. Delta. We have two estimates of Delta at time t. In
f 22 f 21
the up state, u = , and in the down state,
Su 2 S

20-17 20-18

f 21 f 20 h = 0.5(Su2 Sd2). This is roughly equal to Su Sd, as

d = . Gamma is the change in Delta divided
S Sd 2 long as 0.5(u + d) 1, which is true for small t.
by the change in S: We are also interested in the change in the option price with
u d
respect to time, all else being equal. In continuous time,
Gamma = =
( Su Sd )
f
2 2 we call Theta = = .
[( f 22 f 21 ) /( Su S )] [( f 21 f 20 ) /( S Sd )] t
= .
( Su Sd ) For estimating Theta, , note that if u = 1/d, then Sud = S.
NOTE: Hull argues that we should use for the change in S, So, for the partial derivative with respect to t, (which
2 2
half the distance between Su and Sd ; i.e., he divides by assumes that S remains constant) we can use f21, at date
2t, and f00:

20-19 20-20
 f 21 f 00 ASIDE: We could also use a two-sided estimate:
Theta = = .
2t f ( + ) f ( )
Vega = .
f 2
To calculate Vega = , we cant simply use the values that
f
Rho = can be calculated similarly.
appear in the binomial tree; we have to actually calculate r
f using a new volatility, say + , for some small 20.2 USING THE BINOMIAL TREE FOR OPTIONS ON
number and then divide the difference in the option INDICES, CURRENCIES, AND FUTURES

prices by : CONTRACTS
f ( + ) f ( ) In Ch. 16&17, slide 4, we found that futures prices have
Vega = .
zero growth rate in a risk neutral world; i.e.,

20-21 20-22

[FT] = F0.
[We sometimes say that F is a martingale under P .]
We would now like to find similar expectations for indices
and currencies. First, note that if the futures contract
matures at date T, then FT = ST, in general.
Options on Indices
Suppose S represents the price of an index having dividend
yield, q. Then, since ST = FT,
[ST] = [FT] = F0 = S0e( r q )T .
This implies that S has a lower expected growth rate. For a
non-dividend paying stock the risk-neutral expected
growth rate is r, but for a stock paying dividend yield q,
its risk-neutral expected growth rate is r q. Intuitively,
the dividend payments result in lower expected capital
gains.
Next, recall that, in our binomial models, when we choose
the three values, p, u, and d, we have two conditions that
must be satisfied:

20-23 20-24
 S t + t Solving for p, we find that p(u d) + d = e(r q)t, or
Ep[St+t] = [St+t], and Varp(ln ) = 2t.
St
e ( r q ) t d u e ( r q ) t
p= , and 1 p = .
Here, Ep and Varp represent the mean and variance as ud ud
calculated from the binomial model. So, in a one-step tree, the price, f, of an option is
Lets add the third condition: set d = 1/u. f = ertEp[payoff] = ert[pf u + (1 p)f d],
Now, the equation for the variance hasnt changed, so u and where p, u, and d are given by the above equations.
t t
d are the same as before: u = e , d = e . Note that we still discount using the risk-free rate, r;
The risk-neutral expected value has changed, however; we however, the probabilities assume an expected growth
now require that rate of r q.
Ep[St+t] = pStu + (1 p)Std = Ste(r q)t.

20-25 20-26

Options on Currencies: Options on Futures:

Now suppose S represents the price of a foreign currency, For futures, the growth rate is 0 = r r, rather than r q.
where rf = the foreign risk-free rate. Then, So, futures behave like an index with q = r:
( r r f )T t t
[ST] = [FT] = F0 = S0e . u = e , d = e ,
It follows that a currency price behaves much like an index; 1 d u 1
p= , and 1 p = .
ud ud
the growth rate is r rf, rather than r q. So for options
To see this, note that were solving the equation
on currencies, q = rf:
t t
t[Ft+t] = pFtu + (1 p)Ftd = Ft; or, p(u d) + d = 1.
u = e , d = e ,
( r r f ) t ( r r ) t
Again, in a one-step tree, the price, f, of an option is
e d ue f
p= , and 1 p = . f = ertEp[payoff] = ert[pf u + (1 p)f d],
ud ud

20-27 20-28
 so, once we change p, the rest of the problem is almost
the same as for the non-dividend paying stock.
Note that we effectively replace S with F in these
equations. Also, note that these equations hold for any
*
futures contract, regardless of its maturity, T , (as long
*
as T > T, the option maturity) and regardless of the asset
underlying the futures. The only assumption here is that
F is lognormal.
FACT: if an asset has a growth rate that is less than r, (i.e., if
q > 0) then an American call option on that asset may
be exercised early. So, American call options on
indices, currencies, and futures may be exercised early.
Example 1: (Call option on futures). Consider a four-
month American call option on a futures contract when
the futures price is $20, the strike price is $20, the risk-
free rate is 5% per annum, and the volatility is 40% per
annum. Using a two-step binomial tree, find the price of
the American call and the early exercise premium,
assuming d = 1/u. Also, find Delta, Gamma and Theta

20-29 20-30

for the American call as well as the corresponding Heres the tree for the futures prices:
European call. Futures Prices
With our usual notation, this means that F = 20, X = 20, r =
27.7254
0.05, = 0.40, T = 4/12 = 1/3, and we set q = r = 0.05.
23.548
Lets construct the two-step tree for futures prices using X = 20
20 20
the assumption d = 1/u. First, t = T/n = (1/3)/2 = 1/6. 16.986
Now, we have 14.4262
u = e t
= e ( 0.4) 1/ 6
= 1.1774, d = 1/u = 0.8493, t=0 t = 1/6 t = 2/6

1 d 1 0.8493
p= = = 0.4593, 1 p = 0.5407.
u d 1.1774 0.8493 So, for example, Fuu = 20(1.1774)2 = 27.7254.

20-31 20-32
 E
Because X = 20, at maturity the payoffs are f 2,2 = 7.7254, Finally, at time 0,

f 2,1E = 0, f 2,0
E
= 0. f 0E,0 = ert[p f1,E1 + (1 p) f1,E0 ]

Now, if we want the early exercise premium, well have to = e(0.05)/6[(0.4593)(3.5188) + (0.5407)(0)] = 1.603.
calculate the price of the corresponding European call.
At step 1 of the tree for the European call, we have
f1,E1 = ert[p f 2,2
E
+ (1 p) f 2,1E ]

= e(0.05)/6[(0.4593)(7.7254) + (0.5407)(0)] = 3.5188,

f1,E0 = ert[p f 2,1E + (1 p) f 2,0
E
]

= e(0.05)/6[(0.4593)(0) + (0.5407)(0)] = 0,

20-33 20-34

Futures Prices and European Call At step 1 of the tree for the American call, we have
f1,A1 = max{ert[p f 2,2
A
+ (1 p) f 2,1A ] , Fu X}
27.7254
23.548 7.7254 (if continue to hold, if exercise)
3.5188 20 X = 20 = max{3.5188, 23.548 20} = 3.548.
20 0
1.603 16.986 f1,A0 = max{ert[p f 2,1A + (1 p) f 2,0A ], Fd X}
0 14
0 = max{e(0.05)/6[(0.4593)(0) + (0.5407)(0)],
t=0 t = 1/6 t = 2/6
16.986 20} = 0.
Finally, at time 0,
For the American option, we have the same payoffs at
A
f 0A, 0 = max{ert[p f1,A1 + (1 p) f1,A0 ], F X}
maturity: f 2,2 = 7.7254, f 2,1A = 0, f 2,0A = 0.

20-35 20-36
 = max{e(0.05)/6[(0.4593)(3.548) + 0], 20 20} = 1.616. Gamma is given by
The early exercise premium is 1.616 1.603 = 0.013. u d
=
Now, Delta for the American call is given by ( Fu Fd )

A f1,1A f1,0A
3.548 0 3.548 [( f 22 f 21 ) /( Fu 2 F )] [( f 21 f 20 ) /( F Fd 2 )]
= = = = 0.5407. =
Fu Fd 23.548 16.986 6.562 ( Fu Fd )
By comparison, the Delta for the European call is given by [(7.7254 0) /(27.7254 20)] [(0 0) /(20 14.4262)]
=
(23.548 16.986)
E f1,1E f1,0E 3.5188 0
= = = 0.5362. 1
Fu Fd 6.562 = = 0.153. (Note that this is the same for the
6.562
European and American options for the two-step tree.)

20-37 20-38

Theta for the American option is given by Example 3: Let us review the delta-hedging option
f 2,1A f 0,0A 0 1.616 replication argument from Ch. 12 and apply it to options
A= = = 4.848,
2t 2( 2 / 12) on futures. Well just look at the one-period case for a
while Theta for the European option is equal to European call with maturity T. There are two key
E E
f f 0 1.603 differences with futures: the initial value of the futures
E = 2,1 0,0
= = 4.809,
2t 2(2 /12) contract is 0, and the value of the (long) contract at date
Example 2: If F increases by $1, then T is FT F0 = FT F. As usual, suppose we write one
df (0.541)(+1) + 12 (0.153)(+1)2 = 0.6175; call and buy futures. We want to find so that the
if S decreases by $1, then payoff at date T is risk-free, that is, we want
df (0.541)(1) + 12 (0.153)(1) = 0.4645.2
(FT F0) cT = (Fu F) cu = (Fd F) cd.

20-39 20-40
 cu c d = e rT c d ( Fd F ) .
We quickly see that = , as usual (the F terms
Fu Fd
The rest of the problem, including the arbitrage argument, is
cancel). The initial value of this portfolio would be
roughly the same as in Ch. 12. So, if
0 c = c = PV (risk-free payoff ) ,
c > PV ( risk-free payoff ) ,
because the initial value of the futures contract is equal
to 0. Solving for c gives we want to receive c and pay PV ( risk-free payoff ) ; that

c = PV ( risk-free payoff ) is, we write one call, take an off-setting position in

futures by buying futures, and invest
= e rT ( Fu F ) c u
PV ( risk-free payoff ) in the risk-free asset.
= e rT c u ( Fu F )

20-41 20-42

Conversely, if c < PV ( risk-free payoff) then we want u d cu c d

= e rT c u (u 1)
ud ud
to pay c and receive PV ( risk-free payoff ) , so we buy
e rT u
the call, sell futures (an off-setting position) and = c (u d ) (c u c d )(u 1)
ud
borrow PV ( risk-free payoff ) . e rT u
= c (1 d ) + c d (u 1)
ASIDE for those who are interested: Let us show that this ud

gives the correct answer. Substituting for gives = e rT pc u + (1 p )c d ,

cu c d 1 d u 1
e rT c u ( Fu F ) = e rT c u ( Fu F ) where p = and 1 p = , as usual.
Fu Fd ud ud

20-43 20-44
 Example 4: Let us use the first period numbers from
Example 1 and consider the European call only. In this
u
case, F = 20, Fu = 23.548, Fd = 16.986, c = 3.5188,
cd = 0, r = 5% and t = 1/6. Find , p, and the risk-free
payoff if we write one call and buy futures.
Solution: As mentioned above, and p are the same as our
previous calculations: = 0.5362, and p = 0.4593. The
risk-free payoff in the down state is a little easier to
calculate, since cd = 0:
20-45
EXTENSIONS OF THE BASIC TREE APPROACH
th
Control Variate Technique (p. 440 8 Ed.)
The idea here is simple and yet quite powerful. Here we use
the binomial tree to calculate the American option price,
fA, then we use the same tree to calculate the European
option price, fE, and from these two values we calculate
the early exercise premium, fA fE. To get a better
estimate of the American option price, we now add this
early exercise premium to the Black-Scholes price for
20-47
(Fd F) cd = 0.5362(16.986 20) 0 = 1.6155.
So, the call price is given by
c = PV ( risk-free payoff ) = 1.6155e(0.05)(1/6) = 1.603,
which agrees with our previous answer.
20-46
the European option, fBS. So, using the control variate
technique, our estimate of the American option is
fBS + fA fE.
This approach is used in several of the spreadsheets used in
the homework assignment. This approach produces a
considerable improvement over the basic tree estimate of
the American option.
Note that in the limit as t 0, fE fBS; in other words, the
binomial model for European options approaches the
Black-Scholes price in the limit.
20-48
 Example 3: In Example 1, we had a four-month American
call option on a futures contract when F = $20, X = $20,
r = 5% per annum, and = 40% per annum. We found
that fA = 1.616, and fE = 1.603. From Blacks formula
for options on futures, you can check that d1 = 0.12,
d2 = 0.12, N(d1) = 0.5478, N(d2) = 0.4522, and fBS =
1.880. So, our estimate for the price of the American
call is
fBS + fA fE = 1.880 + 1.616 1.603 = 1.893.
20-49
price at the beginning of the time interval, it will be
either Su D or Sd D at the end of the time interval.
At the end of the next time interval, it will be one of
(Su D)u, (Su D)d, (Sd D)u, or (Sd D)d. Since the
two middle terms, (Su D)d and (Sd D)u are not
equal, the tree does not recombine; i.e., (since d = 1/u)
(Su D)d = S Dd (Sd D)u = S Du.
Heres how we can avoid this problem. Suppose the stock
pays one dividend during the life of the option, of dollar
value D, and at date , where (k 1)t < < kt.
20-51
ASIDES:
20.3 BINOMIAL MODEL FOR A DIVIDEND-PAYING
STOCK
Known Dollar Dividend
Here we assume that the dollar amount of the dividend,
rather than the dividend yield, is known in advance.
Unfortunately, if we simply subtract the dividend from the
stock price when it is paid, the tree no longer
recombines. To see this, suppose a dividend equal to D
is paid during a certain time interval. If S is the stock
20-50
In other words, at date (k 1)t, the dividend has not
been paid yet, but by date kt, the dividend has been
paid.
Let me write PV0(D) = Derkt, for the present value of D at
date 0, and PVi(D) = Der(k i)t, for the present value of
the future dividend, D, as of date it, the ith step of the
tree. In particular, if the dividend occurs in the interval
(k 1)t < < kt, then PVk1(D) = Dert D, and
PVk(D) = 0, since we assume that by the kth step of the
20-52
 tree (date kt), the dividend has already been paid,
which means the PV of future dividends becomes zero.
We can write the stock price as S = S PV0(D) + PV0(D),
where PV0(D) is known, and S PV0(D) is the uncertain
part. First, we construct a binomial tree for the uncertain
part; the text calls it S*:
Sij* = [S PV0(D)]u jd i j.
Then, to each Sij*, we add PVi(D), so that the final tree is
[S PV0(D)]u jd i j + PVi(D).
What is this equal to at t = 0?
20-53 20-54
PVi(D) drops (by the amount of the dividend) each time
a dividend is paid.
Example 2: In the Ch. 14 lecture notes, from slide 14-66,
we applied Blacks approximation for American call
options when S = 50 = X, T = 3 months, r = 8%, =
0.20, and the stock pays a $1.50 dividend in 2 months.
Lets set up a 3-period tree for this problem.
(0.08)(2/12)
First, PV0(D) = e (1.50) = 1.4801,
PV1(D) = e(0.08)(1/12)(1.50) = 1.4900, and PV2(D) = 0,
since we assume D is paid just before the second step.
20-55 20-56
Again, note that PVi(D) D just before the dividend is paid,
but PVi(D) = 0 for i > k, so the price does drop on the
ex-dividend date, (by the amount of the dividend) but
the tree still recombines.
Note also that we can easily extend this to multiple dividend
payments by letting PV0(D) be the present value of all
future dividend payments (made during the life of the
option) and by letting PVi(D) be the present value, as of
date it, of all remaining dividends. Again, the value of
Next, u = e t
= e 0.20 1 / 12
= 1.0594, d = 1/u = 0.9439.
Now, S PV0(D) = 50 1.4801 = 48.5199. So, the stock
prices in the tree are
S0,0 = S = 50,
S1,1 = [S PV0(D)]u + PV1(D) = (48.5199)(1.0594) + 1.4900
= 52.8936
S1,0 = [S PV0(D)]d + PV1(D) = (48.5199)(0.9439) + 1.4900
= 47.2880
S2,2 = [S PV0(D)]u2 + PV2(D) = (48.5199)(1.0594)2 + 0
= 54.4588
 S2,1 = [S PV0(D)] + PV2(D) = 48.5199 + 0 = 48.5199 To complete the problem, note that the risk-neutral
2 2
S2,0 = [S PV0(D)]d + PV2(D) = (48.5199)(0.9439) + 0 probability of an up tick is
= 43.2287. e rt d
p= = 0.5436,
S3,3 = [S PV0(D)]u3 = 57.6955, ud

S3,2 = (48.5199)u = 51.4036, S3,1 = (48.5199)d = 45.7979, (there is no dividend yield here), and you can check that

S3,0 = (48.5199)d3 = 40.8035. f A = f E = 6.77; so, in this case the tree is not large

Note that if there had been no dividend payment, then the enough to calculate the early exercise premium. From a

final values would be Su3 = 50(1.0594)3 = 59.4555, 50-step tree, it can be shown that f A = 2.01 and f E =

Su = 52.9717, Sd = 47.1950, and Sd3 = 42.0483, so the 1.70.

dividend payment has reduced these prices.

20-57 20-58

20.6 MONTE CARLO SIMULATION Now, we know how to solve this equation:
Weve discussed Monte Carlo simulation before. (See Ch. ( r q 1 2 ) t +Wt ( r q 1 2 ) t + t
St + t = S t e 2
= St e 2
,
13, pp. 35-42 of my lecture notes.) As we saw in Ch.
where is a standard normal random variable. So, one
13, the first thing we have to understand is what
way to simulate the first path of prices, S0(1), S1(1), ,
stochastic process does our underlying asset follow in a
ST(1), is to generate T independent standard normal
risk-neutral world. Suppose, for example, our
variables, 1(1), 2(1), , T(1). Then, for each i, we set
underlying asset is an index with dividend yield q. In a
( r q 12 2 ) t + i (1) t
Si(1) = Si 1 (1)e .
risk-neutral world, the price follows the Ito process
From this sample path, we calculate the option payoff, fT(1).
dS = (r q)Sdt + SdW.
This payoff may only depend on ST(1), or it may depend
Here, W is a standard Wiener process.

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 on the average of the path, or the maximum of the path, have random risk-free rates associated with each sample
etc. We then repeat this, say, M times, producing option path.
payoffs fT(1), fT(2), , fT(M), where M may be several Several Underlying Variables (An aside for those who
thousand sample paths. Our estimate for the price of the are interested)
option at time zero is then Suppose now we have an option that depends on two
1 underlying processes, whose prices are X and Y. The
f = erT [ fT(1) + fT(2) + + fT(M)],
M returns on X and Y have correlation . When we use
i.e., we use the arithmetic average to estimate the (risk-
EXCEL to generate random numbers, those numbers are
neutral) expected value. Note that it is also possible to
independent. How do we generate random numbers that
have correlation ?

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For the first sample path, lets generate independent normal variables, x, y, and z, the trick is to define
standard normal numbers, x1(1), x2(1), , xT(1), and variables X, Y, and Z by
y1(1), y2(1), , yT(1). If we define new variables X and X = x,
Y by Y = XYx + 1 XY
2
y,
iX (1) = xi(1), and Z = 1x + 2y + 3z,
and iY (1) = xi(1) + 1 2 yi(1), where 1 = XZ,
then X and Y have correlation . YZ XZ XY
2 = 2
,
For three variables, X, Y, and Z, with correlations XY, XZ, 1 XY

and YZ, once we simulate the independent, standard and 3 = 1 12 22 .

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 Larger numbers of variables are possible. For four or more
variables, the trick involves finding the square root of
a matrix, which is known as Cholesky factorization.
Programs like Mathematica, Matlab, and Gauss have
built-in Cholesky factorization codes. I wont go into
the details, but I can provide a reference to those
interested.
20-65
In other words, if we write, = St.Dev[erTfT(i)], where
erTfT(i) is one estimate of the (discounted) option price,
then
St.Dev( f ) = ,
M 20.7 VARIANCE REDUCTION PROCEDURES
where f is the average of the M discounted option
1 M
payoffs: f = e rT fT (i ) ,
M i =1
So, a 95% confidence interval for the price, f , is
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Number of Trials
When we calculate our M discounted option payoffs, one
usually calculates the standard deviation (as well as the
mean) of these discounted payoffs. Denote the mean by
and the standard deviation by . The variable is the
simulations estimate of the value of the derivative. The
standard error of this estimate is
.
M
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1.96
< f <+
1.96
.
M M
So to double the accuracy, we must multiply M by ____?
Antithetical Variable Technique
One way to reduce the variance of our estimate is as
follows: first, using our standard normal variables,
calculate the derivative in the usual way; call this value
f1. Next, change the sign of all the samples from the
20-68
 standard normal distributions; that is, if is the original = 12 [ Var( f1) + Cov( f1, f 2 )],
random value, use to calculate the second value. Call since Var( f1) = Var( f 2 ) (in theory).
this second value f 2 . (We do this for each sample path.) Now, if f1 and f 2 were independent, then Cov( f1, f 2 ) = 0,
Now calculate the mean, f = 12 ( f1 + f 2 ), of these two 2
and we get Var( f ) = 12 Var( f1) = , (for a standard
values. The final estimate of the option is the 2M

(discounted) average of all the f s. Now, weve

deviation of ) so there would be no real benefit
2M
effectively doubled our sample size to 2M sample paths.
here. However, weve constructed f1 and f 2 so that
The variance of this estimate is
Cov( f1, f 2 ) < 0, so we do reduce the variance of our
Var( f ) = 14 Var( f1) + 14 Var( f 2 ) + 12 Cov( f1, f 2 )
estimate significantly.

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20.8 FINITE DIFFERENCE METHODS

In this section we use approximations to solve the Black-
Scholes partial differential equation itself (we use q = 0
for now, where q = dividend yield):
f f 1 2 f
+ rS + 2S2 2 = rf, (20.21)
t S 2 S
or, Theta + rSDelta + 12 2 S 2 Gamma = rf.
Recall that this holds when S follows the Ito process
dS = Sdt + SdW,
or in a risk-neutral world, dS = rSdt + SdW,

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 where W is a standard Wiener process. After this change of variable, equation (20.21) becomes
Before we go any further, it turns out that its more efficient f 1 2 f 1 22 f
+ (r ) + = rf.
to work with ln(S) rather than S; so define Z = ln(S). t 2 Z 2 Z 2

Recall that in a risk-neutral world, Z = ln(S) follows the Again, this assumes dZ = (r 12 2)dt + dW.

generalized Wiener process ASIDE: for those interested in the mathematics, were using
dZ = (r 12 2)dt + dW, the chain rule, and for the second derivative, we need the

which has constant coefficients. So, for example, the product rule. Recall that Z = ln(S):

risk-neutral expected value of Zt+t is

[Zt+t] = Zt + (r 12 2)t

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f f Z f ln(S ) f 1 In general, if the underlying asset follows an Ito process,

= = = ,
S Z S Z S Z S dX = a(X,t)dt + b(X,t)dW,
f
2
f f 1 1 f f 1 in a risk-neutral world, then the Black-Scholes partial
= = = +
S 2
S S S Z S S S Z Z S S
differential equation becomes
1 2 f Z f 1 1 2 f f 1
= 2 2 = 2 2 . f f 1 2 f
S Z S Z S S Z Z S 2 + a(X,t) + b2(X,t) 2 = rf.
t X 2 X
When these are substituted into (20.21) all the S terms
So, this gives us a great deal of flexibility; we can use
cancel.
this approach to model mean-reversion (which is a
nice property for interest rates), or to allow the stocks
volatility to vary as a function of the stocks price.

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 We can now approximate these partial derivatives just as we stays the same, or goes down to Z Z. Note that Z is
did when we calculated the various hedge parameters constant throughout the tree. Heres the tree:
t
from the binomial tree, but in this case, it is a trinomial
Z + Z
tree, which means that the stocks price can either go up, fi+1,j+1
u
go down, or stay the same. Z
Zi,j = Z Z
With this trinomial tree, along the horizontal axis, we have fi,j = ? fi+1,j
constant time changes, t. Along the vertical axis, an
d
up tick now means an increase in Z = ln(S); in fact we Z Z
fi+1,j1
have constant increases and decreases in Z, which well
label Z. So, at each step, Z either goes up to Z + Z,

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(Recall that Z = ln(S).) The partial derivatives are f i +1, j +1 f i +1, j f i +1, j f i +1, j 1
u d
approximated by f
2
Z Z
= .
Z 2
Z Z
f f i +1, j f i , j
= Theta (with respect to Z), Here weve used the next-period option prices to
t t
f i +1, j +1 f i +1, j 1 approximate these derivatives. This is called the explicit
f
= Delta (2-sided),
Z 2Z differences method. I wont discuss the implicit

2 f f i +1, j +1 + f i +1, j 1 2 f i +1, j differences method.

= Gamma.
Z 2
(Z ) 2 Substituting these approximations into our partial
ASIDE: we get the second derivative as follows: differential equation gives

20-79 20-80
 f i +1, j f i , j 1 f i +1, j +1 f i +1, j 1 1 1 1 1 1
+ (r 2) (r + )fi,j = fi+1,j+1[(r 2) + 2 ]
t 2 2Z t 2 2Z 2 (Z ) 2
1 f i +1, j +1 + f i +1, j 1 2 f i +1, j 1 1
+ 2 = rfi,j. + fi+1,j [ 2 ]
2 (Z ) 2 t (Z ) 2
We now solve this equation for fi,j as a function of the next 1 1 1 1
+ fi+1,j1 [(r 2) + 2 ].
period prices: 2 2Z 2 (Z ) 2
Next, we multiply both sides by t [so that the left-hand side
becomes (1 + rt)fi,j] and then divide both sides by
(1 + rt), which gives (see equation (20.36), 8th Ed.)

20-81 20-82

1 You can check that pu, pm, and pd add up to one. If any of
fi,j = [pufi+1,j+1 + pmfi+1,j + pdfi+1,j1]
1 + rt these numbers is negative, you have a problem; youll
= PVEp[payoff], have to decrease t, which means increasing n, the
1 t 1 t
where pu = (r 2) + 2 , number of steps in the tree. It turns out that these are
2 2Z 2 (Z ) 2
risk-neutral probabilities again.
t
pm = 1 2 , ASIDE: To see this, using these probabilities, calculate
(Z ) 2
Ep[ln(St+t)]:
1 t 1 t
and pd = (r 2) + 2 .
2 2Z 2 (Z ) 2 Ep[ln(St+t)] = Ep[Zt+t]
= pu(Zt + Z) + pm(Zt) + pd(Zt Z)

20-83 20-84
 = (pu + pm + pd)(Zt) + Z(pu pd) (Z)2 = 23t, how do the formulas for pu, pm, and pd
1 t 1 simplify?
= Zt + Z(r 2) = Zt + (r 2)t,
2 Z 2 t
2 =
which is what we expect in a risk-neutral world. It is (Z ) 2
also possible to show that 1 t 1 t
pu = (r 2) + 2 =
Varp(Z) Ep[(Zt+T Zt)2]= 2t, 2 2Z 2 (Z ) 2

which is the other condition that we require. t

pm = 1 2 =
(Z ) 2
One final trick is this: it turns out that its optimal to set
1 t 1 t
Z = 3t . pd = (r 2) + 2 =
2 2Z 2 (Z ) 2
Given that its optimal to set Z = 3t , or

20-85 20-86

This is the model used in the spreadsheets , and 2

pm =
. 3
1 t 1
Note that, if the stock pays a dividend yield, q, then the and pd = (r q 2) + .
2 2Z 6
Black-Scholes partial differential equation is
How does the stock price change as we move through the
f f 1 2 f
+ (r q)S + 2S2 2 = rf. tree? At t = 0 (step 0) we have Z = ln(S), or solving for
t S 2 S
S, S = eZ. At step 1, with an up tick we have
and these probabilities become (Z = 3t )
S1,1 = eZ + Z = SeZ = Su;
1 t 1
pu = (r q 2) + , that is, we set u = eZ. In the middle state we have
2 2Z 6
S1,0 = S,

20-87 20-88
 while in the down state, we have d = 1/u,
S1,1 = eZ Z = SeZ = S/u = Sd. (compare the binomial case where u = e t
)
This pattern continues: with two up ticks, the stock price and pu, pm, and pd given by equations
is eZ + 2Z = Se2Z = Su2; with two down ticks, we have 1 t 1
pu = (r q 2) + ,
2 2Z 6
eZ 2Z = Sd2.
2
CONCLUSION AND SUMMARY: the explicit differences pm = ,
3
method of solving the Black-Scholes partial differential
1 t 1
and pd = (r q 2) + .
equation leads to a trinomial tree with 2 2Z 6
3 t
u = eZ = e , (since Z = 3t ), The option price at the (i,j)th node is then

20-89 20-90

fi,j = e rt [ p u f i+1, j +1 + p m fi +1, j + p d fi +1, j 1 ]. the American call and the early exercise premium. Also,

NOTE: To discount, well just use continuous compounding, find Theta for the European and American options.
3 t
as usual, rather than dividing by (1 + rt). The Here T = 4/12, t = 2/12, u = e = e 0.40 32 / 12
= 1.3269,

difference is minimal for small t. d = 0.7536. So, Fu = 26.5379, Fd = 15.0728, Fu2 =

Example 4: Lets re-consider Example 1: a four-month 35.2131, and Fd2 = 11.3594. The payoffs at maturity for

American call option on a futures contract when the call are f2,2 = 15.2131, f2,1 = 6.5379, f2,0 = 0, f2,1 = 0,

F = $20, X = $20, r = 5% per annum, and = 40% per f2,2 = 0.

annum. Using a two-step trinomial tree, find the price of Next,

1 t 1
pu = (r q 2) +
2 2Z 6

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 1 2 / 12 1 Heres the tree:
= [0.05 0.05 (0.4)2] +
2 2(0.40) 3(2 / 12) 6 Fu2
1 Fu Fu
= 0.0236 + = 0.1431
6
F F F
m 2
p = = 0.6667, Fd Fd
3
1 t 1 Fd2
d
p = (r q 2) +
2 2Z 6
1 Substituting in the numerical values gives
= +0.0236 + = 0.1902.
6

20-93 20-94

For the European option, we have

35.2131 f1,E1 = ert[puf2,2 + pmf2,1 + pdf2,0]
Fu 26.5379 = e0.05(2/12)[(0.1431)(15.2131) + (0.6667)(6.5379) + 0]
20 F 20
= 6.4813
Fd 15.0728
f1,E0 = e0.05(2/12)[puf2,1 + pmf2,0 + pdf2,1]
11.3594
= e0.05(2/12)[(0.1431)(6.5379) + 0 + 0] = 0.9278.
f1,E1= e0.05(2/12)[0 + 0 + 0] = 0.
So, working back through the tree, we find the PV of the
risk-neutral expectations. To discount, well just use Finally, the price of the European call is

continuous compounding, as usual. f E = e0.05(2/12)[puf1,1 + pmf1,0 + pdf1,1]

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 = e0.05(2/12)[(0.1431)(6.4813) + (0.6667)(0.9278) + 0] = 1.541,
= 1.533. for an early exercise premium of 1.541 1.533 = 0.008.
(In Example 1, we calculated this price as 1.603.) Also, for the American option,
For the American call, the calculations are almost the same f1,0A f 0A 0.9278 1.541
Theta A = = = 3.679,
except that you exercise the call in the up state in step t 2 /12

one, that is, while for the European option,

f1,A1 = max{Fu X, 6.4813} = 6.5379. f1,0E f 0E 0.9278 1.533

Theta E = = = 3.631.
t 2 /12
So,
f A = e0.05(2/12)[(0.1431)(6.5379) + (0.6667)(0.9278) + 0]

20-97 20-98

18.9 (5th Ed.) ANALYTIC APPROXIMATIONS IN
OPTION PRICING
This approach is due to MacMillan, Barone-Adesi and
Whaley. I wont describe the theory of this approach,
(for details see Analytic Approximation for Valuing
American Options at the web site,
http://www.rotman.utoronto.ca/~hull/TechnicalNotes/ )
except to say that it also involves trying to solve the
Black-Scholes partial differential equation. After a
(different) change of variables, and an assumption that
one term in the derived partial differential equation is
negligible, they arrive at an ordinary differential
equation, which can be solved.
Lets see how to find the price of an American call on a
stock that pays a dividend yield, q. As usual, well let
C(S) = the price of an American call when the stocks
price is S, and c(S) = the price of a European call. First,
we estimate S*, the critical price of the stock above
which the option should be exercised. It is estimated by
solving the equation

20-99 20-100
 * q(T t) * S* * (A2 is another constant.) Note that, in the usual case, S < S*,
c(S ) + {1 e N[d1(S )]} (S X) = 0,
2 S
2
the early exercise premium is A2 .
(Here 2 is a constant.) In EXCEL, we can use to set S*
this equation equal to zero by changing S*. This is what For an American put option, we estimate the early exercise
the spreadsheet does. Now, given this early boundary, S**, by solving the equation
exercise boundary, S*, the price of the American call is S **
p(S**) {1 eq(T t)N[d1(S**)]} (X S**) = 0.
2 1
S *
c( S ) + A2 * when S < S
C(S) = S . Again, once we use EXCELs to find S**, the price of
SX when S S * the American put is

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1
S
p( S ) + A1 when S > S **
P(S) = S ** .
**
X S when S S
The constants 1, 2, A1, and A2 can be found in the textbook.

20-103