Binomial derivative valuation model

Financial Derivatives course

School of Business, Universidad Francisco Marroquı́n

September 2016

Szabolcs Blazsek

1. General setup

We price a derivative of an underlying asset in a one-period setup. The derivative contract is valued at time

t = 0. The expiration date of the derivative is t = T . Hence, the time to expiration is T − t = T − 0 = T . Time

is measured in years. We represent the price of the underlying asset in the following tree:

where u > 0 and d < 0 denote the annual log returns of the underlying asset and S denotes the price of the

underlying asset at time t = 0. Due to the signs of u and d, the price of the underlying asset either goes up to

S[exp(uT )] or goes down to S[exp(dT )]. The payoff of the derivative at time t = T can be represented in the

following tree:

where f is the price of the derivative at time t = 0. (We would like to compute this value.) fu and fd denote

the payoffs of the derivative at maturity, t = T . In the following, we use this general notation for the derivative.

Two examples for special cases:

Example 1: European call option with price c, strike price X and expiration date t = T . The price and the

payoff of this derivative can be represented as follows:

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Example 2: European put option with price p, strike price X and expiration date t = T . The price and the

payoff of this derivative can be represented as follows:

2. First valuation formula (F1)

From the underlying asset and the derivative, we construct a risk-free portfolio that pays the same amount when

the price S goes up and down. Consider the next portfolio: (1) Buy ∆ units of the underlying asset; (2) Sell 1

unit of the derivative. The value of this portfolio and its total payoff are given by

Choose ∆ in such a way that the total payoff of this portfolio is independent from the movement of the

underlying asset price, i.e.

∆S exp(uT ) − fu = ∆S exp(dT ) − fd .

We express ∆ from this equation

fu − fd
∆= .
S exp(uT ) − S exp(dT )

Since the total payoff is the same in both cases, this portfolio is risk-free. Therefore, its value is the same as that

of a zero coupon bond paying the face value ∆S exp(uT ) − fu . Therefore,

exp(−rT ) [∆S exp(uT ) − fu ] = ∆S − f

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with

fu − fd
∆= .
S exp(uT ) − S exp(dT )

Substituting ∆ into the previous equation we have

 
fu − fd fu − fd
exp(−rT ) S exp(uT ) − fu = S−f
S exp(uT ) − S exp(dT ) S exp(uT ) − S exp(dT )

where r is the annual risk-free rate. Expressing f from this equation we get the first pricing formula of the

derivative:

 
fu − fd (fu − fd ) exp(uT )
f= − exp(−rT ) − fu (F1)
exp(uT ) − exp(dT ) exp(uT ) − exp(dT )

Notice that we did not assume what is the probability of the increase or fall of the price of the underlying asset.

3. Second valuation formula (F2)

We start from formula (F1) to get an alternative formula for the price of the derivative.

 
fu − fd (fu − fd ) exp(uT )
f= − exp(−rT ) − fu
exp(uT ) − exp(dT ) exp(uT ) − exp(dT )

 
(fu − fd ) exp(rT ) (fu − fd ) exp(uT )
exp(rT )f = − − fu
exp(uT ) − exp(dT ) exp(uT ) − exp(dT )

f exp(rT )[exp(uT ) − exp(dT )] = (fu − fd ) exp(rT ) − (fu − fd ) exp(uT ) + fu [exp(uT ) − exp(dT )]

f exp(rT )[exp(uT ) − exp(dT )] = fu exp(rT ) − fd exp(rT ) − fu exp(uT ) + fd exp(uT ) + fu exp(uT ) − fu exp(dT )

f exp(rT )[exp(uT ) − exp(dT )] = fu exp(rT ) − fd exp(rT ) + fd exp(uT ) − fu exp(dT )

f exp(rT )[exp(uT ) − exp(dT )] = fu exp(rT ) − fd exp(rT ) + fd exp(uT ) − fu exp(dT ) − exp(dT )fd + exp(dT )fd

f exp(rT )[exp(uT ) − exp(dT )] = [exp(rT ) − exp(dT )]fu + [exp(uT ) − exp(dT )]fd − [exp(rT ) − exp(dT )]fd
 
exp(rT ) − exp(dT ) exp(rT ) − exp(dT )
f = exp(−rT ) fu + fd − fd
exp(uT ) − exp(dT ) exp(uT ) − exp(dT )
   
exp(rT ) − exp(dT ) exp(rT ) − exp(dT )
f = exp(−rT ) fu + 1 − fd
exp(uT ) − exp(dT ) exp(uT ) − exp(dT )

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We define

exp(rT ) − exp(dT )
p=
exp(uT ) − exp(dT )

and substitute p into the previous equation:

f = exp(−rT )[pfu + (1 − p)fd ] (F2)

This is the second valuation formula of the derivative. If d < r < u then 0 < p < 1. p can be called the

‘probability’ of payoff fu and (1 − p) can be called the ‘probability’ of payoff fd . Nevertheless, the ‘probability’ p

is not a probability of the event that S increases. It is just a mathematical construction that is used for pricing

purposes. The p is called ‘risk-neutral probability’ and the (F2) formula does ‘risk-neutral valuation’ of the

derivative. Notice again that we did not assume what is the probability of the increase or fall of the price of the

underlying asset.

4. Conclusion

The price of a derivative in the one-period binomial model can be computed in two ways:

 
fu − fd (fu − fd ) exp(uT )
f= − exp(−rT ) − fu (F1)
exp(uT ) − exp(dT ) exp(uT ) − exp(dT )

and

exp(rT ) − exp(dT )
f = exp(−rT )[pfu + (1 − p)fd ] where p = (F2)
exp(uT ) − exp(dT )

These formulas are equivalent. To compute f , we need: (1) price of the underlying asset at time t = 0, S; (2)

annual log-return of price increase of S, u; (3) annual log-return of price decrease of S, d; (4) exact definition of

the derivative contract (i.e., strike price, payoff function, etc.); (5) annual risk-free interest rate, r.