Question

11.7 What are the formulas for u and d in terms of volatility?

Solution
Matching Volatility with u and d When constructing binomial trees, choose u and d to match the volatility of the stock price. We present the following method: Let be the expected return on the stock (in the real world). Let be the volatility.

 The volatility of a stock price is dened so that is the standard deviation of the return on the stock price in a short period of time of length t. Let t be the interval of time. Suppose the stock price starts at S0 and stock moves to either S0 u or S0 d at the end of t

 S0 u Upward Price S0 d Downward Price S0 u p* S0 1- p* S0 d

Important points to note

Continuous random model for the stock price: dS = Sdt + SdW The binomial model for the stock price is a discrete time model: The stock price S changes only at discrete times t, 2t, 3t, ... The price either moves up S Su or down S Sd with d < ert < u. Probability of up movement is p*

Expected Stock Price:

Expected stock price E (S) = S0 et (As per continuous model) Expected stock price E (S) = p* S0 u + (1 p*) S0 d (As per binomial model) Which should match the return. Then p* S0 u + (1 p*) S0 d = S0 et --------------> (1)

 Therefore,

e t d p * u d

Now we use the volatility into the picture. Since the volatility is the standard deviation of the return on the stock price over short periods of time t, then 2t is the variance on the return on the stock price over short periods of time.

Variance of return
Var(x) = E(X2) *E(X)+ 2 Variance on the return is Var (x) = 2 t (As per continuous model) Variance on the return is Var (x) = p* u2 + (1- p*) d2 - [p* u + (1- p*) d] 2 (As per binomial model) p* u2 + (1- p*) d2 - [p* u + (1- p*) d] 2 = 2 t ------------------> (2)

 As we know u = d-1 Substitute p* in 2 we will get et (u+d) ud - e2t = 2 t Substitute d the above equation et (u+1/u) 1 - e2t = 2 t

 (u+1/u) = 2 t +1 + e2t

(u+1/u) = {2 t e-t + e-t + et } Say {2 t e-t + e-t + et } = k The above equation will become u2 uk +1 =0

 The equation we have got is a quadratic equation hence the solution is

k k2 4 u 2

By simplifying the above we will get

Answer

ue

t
t

d e

Thank You