DERIVATIVES

Week 7
“Derivatives in and of themselves are not evil. There’s nothing evil
about how they’re traded, how they are accounted for, and how
they’re financed, like any other financial instrument, if done
properly”
James Chanos
What does this quote mean?
2
 DISCUSSION TOPICS

• Status • Important Technical Stuff

• Roll Call & Presentation

• Binomial Trees with Dividends

• Binomial Trees

• Next Steps
• Two Step Binomial Trees

• Questions

3
STATUS

4
 STATUS

Week Topic Status Week Topic Status

Week 1 Introduction to Derivatives Complete Week 8 Mid-Semester Break

Week 2 Futures and Forwards Complete Week 9 Black-Scholes-Merton Option

Pricing
Week 3 Interest Rate Futures Complete Week 10 Mid-semester Test

Week 4 Quiz & Margin, Trading & Complete Week 11 Debt Pricing & Yield Curves
Closing out
Week 5 Options Complete Week 12 Hedging & Basis Risk

Week 6 Put-call Parity & Arbitrage Complete Week 13 Swaps

Week 7 Binomial Tree Option Pricing Week 14 Lessons from the Real World
5
ROLL CALL

6
7
PRESENTATION

8
PRESENTATION

Who’s First?

9
BINOMIAL TREES

10
 BINOMIAL TREES

Sounds complex but…

It’s really two equations and a process

11
 BINOMIAL TREES
• 𝑆0 : 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 𝑡𝑜𝑑𝑎𝑦
The equations are:
• 𝑓: 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑛𝑜𝑑𝑒

• 𝑇: 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠 𝑜𝑓 𝑎 𝑏𝑟𝑎𝑛𝑐ℎ 𝑜𝑓 𝑡ℎ𝑒 𝑡𝑟𝑒𝑒

Probability of a move up in price…
• 𝑆0 𝑢: 𝑡ℎ𝑒 𝑢𝑝 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘

𝑒 𝑟𝑇 − 𝑑 • 𝑆0 𝑑: 𝑡ℎ𝑒 𝑑𝑜𝑤𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘

𝑝=
𝑢−𝑑 • 𝑢: 1 + 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 𝑚𝑜𝑣𝑒 𝑢𝑝 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
Nodal option price:
• 𝑑: 1 − 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 𝑚𝑜𝑣𝑒 𝑑𝑜𝑤𝑛 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒

𝑓 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢 + 1 − 𝑝 × 𝑓𝑑 • 𝑓𝑢 : 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑖𝑓 𝑖𝑡 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑚𝑜𝑣𝑒𝑠 𝑢𝑝 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

• 𝑓𝑑 : 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑖𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑚𝑜𝑣𝑒𝑠 𝑑𝑜𝑤𝑛 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

Everything else is a process • 𝑟: 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒

12
• 1 − 𝑝 = 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑎 𝑚𝑜𝑣𝑒 𝑑𝑜𝑤𝑛 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
 BINOMIAL TREES

• Suppose we have a stock currently priced

at $20
• In three months there are only two
outcomes for this stock, either:
Stock price = $20 • A 10% proportional move up, or
• A 10% proportional move down

• How much would you pay for a call option

on this stock with a strike price of $21if
the risk free rate is 12%?
13
 BINOMIAL TREES

• Suppose we have a stock currently priced

Stock price = ?
at $20
Call option with a Option price = ?
$21 strike price • In three months there are only two
has a premium of ? outcomes for this stock, either:
Stock price = $20 • A 10% proportional move up, or
• A 10% proportional move down

Stock price = ?
Option price = ? • How much would you pay for a call option
on this stock with a strike price of $21if
the risk free rate is 12%?
14
 BINOMIAL TREES

• Suppose we have a stock currently priced

Stock price = $22
at $20
Call option with a Option price = ?
$21 strike price • In three months there are only two
has a premium of ? outcomes for this stock, either:
Stock price = $20 • A 10% proportional move up, or
• A 10% proportional move down

Stock price = $18

Option price = ? • How much would you pay for a call option
on this stock with a strike price of $21if
the risk free rate is 12%?
15
 BINOMIAL TREES

• Suppose we have a stock currently priced

Stock price = $22
at $20
Call option with a Option price = $1
$21 strike price • In three months there are only two
has a premium of ? outcomes for this stock, either:
Stock price = $20 • A 10% proportional move up, or
• A 10% proportional move down

Stock price = $18

Option price = $0 • How much would you pay for a call option
on this stock with a strike price of $21if
the risk free rate is 12%?
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 BINOMIAL TREES

𝑢 = 1 + 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 𝑚𝑜𝑣𝑒 𝑢𝑝 = 1.1

𝑑 = 1 − 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 𝑚𝑜𝑣𝑒 𝑑𝑜𝑤𝑛 = 0.9
Stock price = $22 𝑟 = 0.12 𝑖𝑒 12%
Option price = $1 𝑇 = 0.25 𝑖𝑒 3 𝑚𝑜𝑛𝑡ℎ𝑠
𝑓𝑢 = 1
𝑓𝑑 = 0
Stock price = $20 𝑒 0.12×0.25 − 0.9
𝑝= = 0.6523
1.1 − 0.9

𝑓 = 𝑒 −0.12×0.25 0.6523 × 1 + 1 − 0.6523 × 0

Stock price = $18
Option price = $0
𝑓 = $0.633

Thus, would pay $0.63 for this option

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TWO STEP BINOMIAL TREES

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 TWO STEP BINOMIAL TREES

• Two step binomial trees are just like single step binomial trees except you repeat the
process multiple times

• The trick is to calculate the stock price FIRST, which means working from left to right,
then…

• You calculate the price of the option SECOND, which means working from right to left

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 TWO STEP BINOMIAL TREES

• Suppose we have a stock currently priced

at $20
• Every three months there are only two
outcomes for this stock, either:
• A 10% proportional move up, or
$20
• A 10% proportional move down

• How much would you pay for a six-month

call option on this stock with a strike price
of $21 if the risk free rate was 12%?
20
 TWO STEP BINOMIAL TREES

Working left to right we can calculate the

price of the stock at each node

$22 • 𝑆0 𝑢 = 20 × 1.1 = $22

$20
• 𝑆0 𝑑 = 20 × 0.9 = $18

$18

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 TWO STEP BINOMIAL TREES

Working left to right we can calculate the

$24.20
price of the stock at each node
• 𝑆0 𝑢 = 20 × 1.1 = $22
$22
• 𝑆0 𝑢𝑢 = 20 × 1.1 × 1.1 = $24.20
$20
$19.80 • 𝑆0 𝑑 = 20 × 0.9 = $18
• 𝑆0 𝑑𝑑 = 20 × 0.9 × 0.9 = $16.20
$18
• 𝑆0 𝑢𝑑 = 20 × 1.1 × 0.9 = $19.80
$16.20
• 𝑆0 𝑑𝑢 = 20 × 0.9 × 1.1 = $19.80
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 TWO STEP BINOMIAL TREES

Determine the payoff of the option at

$24.20 expiry given the option is a call with a
$3.20 strike of $21
$22
• 𝑓𝑢𝑢 = 𝑚𝑎𝑥 24.20 − 21.00,0 = $3.20
$20 • 𝑓𝑢𝑑 = 𝑚𝑎𝑥 19.80 − 21.00,0 = $0
$19.80
$0.00
• 𝑓𝑑𝑑 = 𝑚𝑎𝑥 16.20 − 21.00,0 = $0
$18

$16.20
$0.00
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 TWO STEP BINOMIAL TREES

Determine the price of the option three months from expiry

(ie 𝑓𝑢 and 𝑓𝑑)
$24.20
$3.20 𝑒 𝑟𝑇 − 𝑑 𝑒 0.12×0.25 − 0.9
$22 𝑝= = = 0.6523
𝑢−𝑑 1.1 − 0.9
$2.0257
$20 𝑓𝑑 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑑𝑢 + 1 − 𝑝 × 𝑓𝑑𝑑 = 0
$19.80
$0.00
𝑓𝑢 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢𝑢 + 1 − 𝑝 × 𝑓𝑢𝑑
$18
$0.00 𝑓𝑢 = 𝑒 −0.12×0.25 × 0.6523 × 3.20 + 1 − 0.6523 × 0
= $2.0257
$16.20
$0.00
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 TWO STEP BINOMIAL TREES

Determine the price of the option today (ie 𝑓)

$24.20
$3.20 • No need to calculate p again as u and d were
$22
constant. We would need to calculate p again if
$2.0257 they were not constant
$20
$19.80
$1.28
$0.00 𝑓 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢 + 1 − 𝑝 × 𝑓𝑑
$18
$0.00 𝑓 = 𝑒 −0.12×0.25 × 0.6523 × 2.0257 + 1 − 0.6523 × 0
$16.20 = $1.2823 = $1.28
$0.00
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 TWO STEP BINOMIAL TREES

Exercise 1: Determine the price of an European

put option
• Suppose we have a stock currently priced at $50
• Each year there are only two outcomes for this
stock, either:
• A 20% proportional move up, or
$50 • A 20% proportional move down

• How much would you pay for a two-year European

put option on this stock with a strike price of $52 if
the risk free rate was 5%?

26
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60

$60
𝑆0 𝑑 = 50 × 0.8 = $40

$50

$40

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 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60

$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$60
𝑆0 𝑑 = 50 × 0.8 = $40

$50
$48 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32

𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48

$40

$32

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 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60

$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$0
$60 𝑆0 𝑑 = 50 × 0.8 = $40

$50 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32

$48
$4
𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48

$40
𝑓𝑢𝑢 = 𝑚𝑎𝑥 − 72 − 52 , 0 = $0

$32
𝑓𝑢𝑑 = 𝑚𝑎𝑥 − 48 − 52 , 0 = $4
$20
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𝑓𝑑𝑑 = 𝑚𝑎𝑥 − 32 − 52 , 0 = $20
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60 𝑒 0.05×1 − 0.8

𝑝= = 0.6282
1.2 − 0.8
$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$0 𝑓𝑢 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢𝑢 + 1 − 𝑝 × 𝑓𝑢𝑑

$60 𝑆0 𝑑 = 50 × 0.8 = $40 = 𝑒 −0.05×1 × 0.6282 × 0 + 1 − 0.6282 × 4 = $1.4147

$1.4147
$50 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32 𝑓𝑑 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑑𝑢 + 1 − 𝑝 × 𝑓𝑑𝑑
$48 = 𝑒 −0.05×1 × 0.6282 × 4 + 1 − 0.6282 × 20 = $9.4636
$4
𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48

$40
$9.4636 𝑓𝑢𝑢 = 𝑚𝑎𝑥 − 72 − 52 , 0 = $0

$32
𝑓𝑢𝑑 = 𝑚𝑎𝑥 − 48 − 52 , 0 = $4
$20
30
𝑓𝑑𝑑 = 𝑚𝑎𝑥 − 32 − 52 , 0 = $20
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60 𝑒 0.05×1 − 0.8

𝑝= = 0.6282
1.2 − 0.8
$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$0 𝑓𝑢 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢𝑢 + 1 − 𝑝 × 𝑓𝑢𝑑

$60 𝑆0 𝑑 = 50 × 0.8 = $40
= 𝑒 −0.05×1 × 0.6282 × 0 + 1 − 0.6282 × 4 = $1.4147

$1.4147
𝑓𝑑 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑑𝑢 + 1 − 𝑝 × 𝑓𝑑𝑑
$50 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32
$48 = 𝑒 −0.05×1 × 0.6282 × 4 + 1 − 0.6282 × 20 = $9.4636
$4.19
$4
𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48
𝑓 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢 + 1 − 𝑝 × 𝑓𝑑
$40 = 𝑒 −0.05×1 × 0.6282 × 1.4147 + 1 − 0.6282 × 9.4636
$9.4636 𝑓𝑢𝑢 = 𝑚𝑎𝑥 − 72 − 52 , 0 = $0 = $4.1923

$32
𝑓𝑢𝑑 = 𝑚𝑎𝑥 − 48 − 52 , 0 = $4
$20 A: $4.19
31
𝑓𝑑𝑑 = 𝑚𝑎𝑥 − 32 − 52 , 0 = $20
AMERICAN OPTIONS

32
 AMERICAN OPTIONS

So far, we have looked at European options. That is, options that can’t be exercised before
expiry

What happens when we have American options, which can be exercised before expiry?

Hint: Europeans stick to the rules, whilst Americans do what they like whenever they like

33
 AMERICAN OPTIONS

• As American options can be exercised early, we need to add a new step into our
option pricing process as we move from right to left

• In addition to calculating the theoretical option price, we also MUST calculate the
value of the option from early exercise

• The maximum of those two option values is used as we move from right to left

34
 TWO STEP BINOMIAL TREES

Exercise 2: Determine the price of an

AMERICAN put option
• Suppose we have a stock currently priced at $50
• Each year there are only two outcomes for this
stock, either:
• A 20% proportional move up, or
$50 • A 20% proportional move down

• How much would you pay for a two-year American

put option on this stock with a strike price of $52 if
the risk free rate was 5%?

35
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60

$60
𝑆0 𝑑 = 50 × 0.8 = $40

$50

$40

36
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60

$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$60
𝑆0 𝑑 = 50 × 0.8 = $40

$50
$48 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32

𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48

$40

$32

37
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60

$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$0
$60 𝑆0 𝑑 = 50 × 0.8 = $40

$50 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32

$48
$4
𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48

$40
𝑓𝑢𝑢 = 𝑚𝑎𝑥 − 72 − 52 , 0 = $0

$32
𝑓𝑢𝑑 = 𝑚𝑎𝑥 − 48 − 52 , 0 = $4
$20
38
𝑓𝑑𝑑 = 𝑚𝑎𝑥 − 32 − 52 , 0 = $20
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60 𝑒 0.05×1 − 0.8

𝑝= = 0.6282
1.2 − 0.8
$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$0 𝑓𝑢 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢𝑢 + 1 − 𝑝 × 𝑓𝑢𝑑

$60 𝑆0 𝑑 = 50 × 0.8 = $40 = 𝑒 −0.05×1 × 0.6282 × 0 + 1 − 0.6282 × 4 = $1.4147

$1.4147
$50 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32 𝑓𝑑 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑑𝑢 + 1 − 𝑝 × 𝑓𝑑𝑑
$48 = 𝑒 −0.05×1 × 0.6282 × 4 + 1 − 0.6282 × 20 = $9.4636
$4
𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48

$40
$9.4636 𝑓𝑢𝑢 = 𝑚𝑎𝑥 − 72 − 52 , 0 = $0

$32
𝑓𝑢𝑑 = 𝑚𝑎𝑥 − 48 − 52 , 0 = $4
$20
39
𝑓𝑑𝑑 = 𝑚𝑎𝑥 − 32 − 52 , 0 = $20
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60 𝑒 0.05×1 − 0.8

𝑝= = 0.6282
1.2 − 0.8
$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$0 𝑓𝑢 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢𝑢 + 1 − 𝑝 × 𝑓𝑢𝑑

$60 𝑆0 𝑑 = 50 × 0.8 = $40 = 𝑒 −0.05×1 × 0.6282 × 0 + 1 − 0.6282 × 4 = $1.4147
𝑓𝑢,𝑒𝑥𝑒𝑟𝑐𝑖𝑠𝑒 = max(− 60 − 52 , 0) = 0
$1.4147
$50 $0 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32
$48 𝑓𝑑 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑑𝑢 + 1 − 𝑝 × 𝑓𝑑𝑑
$4 = 𝑒 −0.05×1 × 0.6282 × 4 + 1 − 0.6282 × 20 = $9.4636
𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48
𝑓𝑑,𝑒𝑥𝑒𝑟𝑐𝑖𝑠𝑒 = max − 40 − 52 , 0 = $12
$40
$9.4636 𝑓𝑢𝑢 = 𝑚𝑎𝑥 − 72 − 52 , 0 = $0
$12
$32
𝑓𝑢𝑑 = 𝑚𝑎𝑥 − 48 − 52 , 0 = $4
$20
40
𝑓𝑑𝑑 = 𝑚𝑎𝑥 − 32 − 52 , 0 = $20
 TWO STEP BINOMIAL TREES

𝑆0 𝑢 = 50 × 1.2 = $60 𝑒 0.05×1 − 0.8

𝑝= = 0.6282
1.2 − 0.8
$72 𝑆𝑜 𝑢𝑢 = 50 × 1.2 × 1.2 = $72

$0 𝑓𝑢 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢𝑢 + 1 − 𝑝 × 𝑓𝑢𝑑

$60 𝑆0 𝑑 = 50 × 0.8 = $40
= 𝑒 −0.05×1 × 0.6282 × 0 + 1 − 0.6282 × 4 = $1.4147
𝑓𝑢,𝑒𝑥𝑒𝑟𝑐𝑖𝑠𝑒 = max(− 60 − 52 , 0) = 0
$1.4147
$50 $0 𝑆0 𝑑𝑑 = 50 × 0.8 × 0.8 = $32
$48 𝑓𝑑 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑑𝑢 + 1 − 𝑝 × 𝑓𝑑𝑑
$5.09
$4 = 𝑒 −0.05×1 × 0.6282 × 4 + 1 − 0.6282 × 20 = $9.4636
𝑆0 𝑢𝑑 = 50 × 1.2 × 0.8 = $48 𝑓𝑑,𝑒𝑥𝑒𝑟𝑐𝑖𝑠𝑒 = max − 40 − 52 , 0 = $12
$40
$9.4636 𝑓𝑢𝑢 = 𝑚𝑎𝑥 − 72 − 52 , 0 = $0 𝑓 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢 + 1 − 𝑝 × 𝑓𝑑
$12 = 𝑒 −0.05×1 × 0.6282 × 1.4147 + 1 − 0.6282 × 12
$32
𝑓𝑢𝑑 = 𝑚𝑎𝑥 − 48 − 52 , 0 = $4 = $5.0894
$20
A: $5.09
41
𝑓𝑑𝑑 = 𝑚𝑎𝑥 − 32 − 52 , 0 = $20
IMPORTANT TECHNICAL STUFF

42
 IMPORTANT TECHNICAL STUFF

Delta Calculating 𝒖 and 𝒅

• Delta is the ratio of the change in the price of the stock • 𝒖 and 𝒅 actually are calculated based upon the price
option to the change in the price of the underlying stock volatility of the underlying stock (𝜎)
• It is the hedging ratio 𝑢 = 𝑒 𝜎√∆𝑡
1
• The delta of a call option is positive (ie buy the 𝑑=
underlying) 𝑢
• ∆𝑡: 𝑖𝑠 𝑡ℎ𝑒 𝑙𝑒𝑛𝑔𝑡ℎ 𝑜𝑓 𝑜𝑛𝑒 𝑡𝑖𝑚𝑒 𝑠𝑡𝑒𝑝 𝑖𝑛 𝑡ℎ𝑒 𝑡𝑟𝑒𝑒 (𝑦𝑒𝑎𝑟𝑠)
• The delta of a put option is negative (ie sell the
underlying) Note:
𝑓𝑢 − 𝑓𝑑 𝒖 = 𝟏 + 𝒑𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒍 𝒎𝒐𝒗𝒆 𝒖𝒑 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆
∆=
𝑆0 𝑢 − 𝑆0 𝑑 𝒅 = 𝟏 − 𝒑𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒍 𝒎𝒐𝒗𝒆 𝒅𝒐𝒘𝒏 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆

43
BINOMIAL TREES WITH DIVIDENDS

44
 BINOMIAL TREES WITH DIVIDENDS

Up to now, we have valued the option for a stock that pays no dividends

But what happens when there is a dividend

Thankfully, the tree branches at each event…such as a dividend payment

45
 BINOMIAL TREES WITH DIVIDENDS
• 𝑆0 : 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 𝑡𝑜𝑑𝑎𝑦 𝑢 = 𝑒 𝜎√∆𝑡
• 𝑓: 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 𝑡𝑜𝑑𝑎𝑦
1
• 𝑇: 𝑡𝑖𝑚𝑒 𝑡𝑜 𝑒𝑥𝑝𝑖𝑟𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑑=
𝑢
• 𝑆0 𝑢: 𝑡ℎ𝑒 𝑢𝑝 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘

• 𝑆0 𝑑: 𝑡ℎ𝑒 𝑑𝑜𝑤𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑒 𝑟𝑇 − 𝑑

𝑝=
𝑢−𝑑
• 𝑢: 1 + 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 𝑚𝑜𝑣𝑒 𝑢𝑝 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒

• 𝑑: 1 − 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 𝑚𝑜𝑣𝑒 𝑑𝑜𝑤𝑛 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒

• Option price: 𝑓 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢 + 1 − 𝑝 × 𝑓𝑑
• 𝑓𝑢 : 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑖𝑓 𝑖𝑡 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑚𝑜𝑣𝑒𝑠 𝑢𝑝 𝑎𝑡 𝑒𝑥𝑝𝑖𝑟𝑦

• 𝑓𝑑 : 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑖𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑚𝑜𝑣𝑒𝑠 𝑑𝑜𝑤𝑛 𝑎𝑡 𝑒𝑥𝑝𝑖𝑟𝑦 • Delta of the option: ∆=
𝑓𝑢 −𝑓𝑑
𝑆0 𝑢−𝑆0 𝑑
• 𝑟: 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒

• 𝑑𝑖𝑣𝑥 : 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡𝑥

• 𝑆𝑥′ = 𝑆𝑥 − 𝑑𝑖𝑣𝑥
• 𝑆𝑥′ : 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑎𝑡 𝑝𝑜𝑠𝑖𝑡𝑖𝑜𝑛 x𝑎𝑓𝑡𝑒𝑟 𝑡ℎ𝑒 𝑖𝑚𝑝𝑎𝑐𝑡 𝑜𝑓 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 46
 BINOMIAL TREES WITH DIVIDENDS

Exercise 3: Determine the price of a EUROPEAN call

option that pays dividends
• Suppose we have a stock currently priced at $50
• Each six months there are only two outcomes for this
stock, either:
• A 10% move up, or
• A 10% move down
$50
• Each six months the stock pays a dividend of $2

• How much would you pay for a one-year European call

option on this stock with a strike price of $52 if the risk
free rate was 5%?

47
 BINOMIAL TREES WITH DIVIDENDS

𝑆0 𝑢 = 50 × 1.1 = $55

$55 𝑆0 𝑑 = 50 × 0.9 = $45

$50

$45

48
 BINOMIAL TREES WITH DIVIDENDS

𝑆0 𝑢 = 50 × 1.1 = $55
𝑆0′ 𝑢 = 55 − 2 = $53

$55 𝑆0 𝑑 = 50 × 0.9 = $45

$53 𝑆0′ 𝑑 = 45 − 2 = $43

$50

$45
$43

49
 BINOMIAL TREES WITH DIVIDENDS

𝑆0 𝑢 = 50 × 1.1 = $55
𝑆0′ 𝑢 = 55 − 2 = $53
$58.30 𝑆𝑜 𝑢𝑢 = 53 × 1.1 = $58.30

$55 𝑆0 𝑑 = 50 × 0.9 = $45

$53 𝑆0′ 𝑑 = 45 − 2 = $43
𝑆0 𝑑𝑑 = 43 × 0.9 = $38.70

$50 $47.70 𝑆0 𝑢𝑑 = 53 × 0.9 = $47.70

$45 𝑆0 𝑑𝑢 = 43 × 1.1 = $47.30

$43 $47.30

$38.70

50
 BINOMIAL TREES WITH DIVIDENDS

𝑆0 𝑢 = 50 × 1.1 = $55
𝑆0′ 𝑢 = 55 − 2 = $53
$58.30 𝑆𝑜 𝑢𝑢 = 53 × 1.1 = $58.30
$56.30 𝑆0′ 𝑢𝑢 = 58.30 − 2 = $56.30
$55 𝑆0 𝑑 = 50 × 0.9 = $45
$53 𝑆0′ 𝑑 = 45 − 2 = $43
𝑆0 𝑑𝑑 = 43 × 0.9 = $38.70
𝑆0′ 𝑑𝑑 = 38.70 − 2 = $36.70
$50 $47.70 𝑆0 𝑢𝑑 = 53 × 0.9 = $47.70
$45.70 𝑆0′ 𝑢𝑑 = 47.70 − 2 = $45.70
$45 𝑆0 𝑑𝑢 = 43 × 1.1 = $47.30
$43 $47.30 𝑆0′ 𝑑𝑢 = 47.30 − 2 = $45.30

$45.30

$38.70
$36.70

51
 BINOMIAL TREES WITH DIVIDENDS

𝑆0 𝑢 = 50 × 1.1 = $55
𝑆0′ 𝑢 = 55 − 2 = $53
$58.30 𝑆𝑜 𝑢𝑢 = 53 × 1.1 = $58.30
$56.30 𝑆0′ 𝑢𝑢 = 58.30 − 2 = $56.30
$55 𝑆0 𝑑 = 50 × 0.9 = $45
$53 $4.30 𝑆0′ 𝑑 = 45 − 2 = $43
𝑆0 𝑑𝑑 = 43 × 0.9 = $38.70
𝑆0′ 𝑑𝑑 = 38.70 − 2 = $36.70
$50 $47.70 𝑆0 𝑢𝑑 = 53 × 0.9 = $47.70
$45.70 𝑆0′ 𝑢𝑑 = 47.70 − 2 = $45.70
$45 $0 𝑆0 𝑑𝑢 = 43 × 1.1 = $47.30
$43 $0 $47.30 𝑆0′ 𝑑𝑢 = 47.30 − 2 = $45.30

$45.30
𝑓𝑢𝑢 = 𝑚𝑎𝑥 56.3 − 52 , 0 = $4.30
$38.70
$0 $36.70
𝑓𝑢𝑑 = 𝑚𝑎𝑥 45.70 − 52 , 0 = $0
𝑓𝑑𝑢 = 𝑚𝑎𝑥 45.30 − 52 , 0 = $0
𝑓𝑑𝑑 = 𝑚𝑎𝑥 36.70 − 52 , 0 = $0 52
 BINOMIAL TREES WITH DIVIDENDS

𝑆0 𝑢 = 50 × 1.1 = $55 𝑒 0.05×0.5 − 0.9

𝑆0′ 𝑢 = 55 − 2 = $53 𝑝= = 0.6266
1.1 − 0.9
$58.30 𝑆𝑜 𝑢𝑢 = 53 × 1.1 = $58.30
$56.30 𝑆0′ 𝑢𝑢 = 58.30 − 2 = $56.30
$55 𝑆0 𝑑 = 50 × 0.9 = $45 𝑓𝑢 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢𝑢 + 1 − 𝑝 × 𝑓𝑢𝑑
$53 $4.30 𝑆0′ 𝑑 = 45 − 2 = $43 = 𝑒 −0.05×0.5 × 0.6266 × 4.30 + 1 − 0.6266 × 0 = $2.6279
𝑆0 𝑑𝑑 = 43 × 0.9 = $38.70
$2.6279 𝑆0′ 𝑑𝑑 = 38.70 − 2 = $36.70
$50 $47.70 𝑆0 𝑢𝑑 = 53 × 0.9 = $47.70 𝑓𝑑 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑑𝑢 + 1 − 𝑝 × 𝑓𝑑𝑑
$45.70 𝑆0′ 𝑢𝑑 = 47.70 − 2 = $45.70 = 𝑒 −0.05×0.5 × 0.6266 × 0 + 1 − 0.6266 × 0 = $0
$45 $0 𝑆0 𝑑𝑢 = 43 × 1.1 = $47.30
$43 $0 $47.30 𝑆0′ 𝑑𝑢 = 47.30 − 2 = $45.30

$45.30
$0
𝑓𝑢𝑢 = 𝑚𝑎𝑥 56.3 − 52 , 0 = $4.30
$38.70
$0 $36.70
𝑓𝑢𝑑 = 𝑚𝑎𝑥 45.70 − 52 , 0 = $0
𝑓𝑑𝑢 = 𝑚𝑎𝑥 45.30 − 52 , 0 = $0
𝑓𝑑𝑑 = 𝑚𝑎𝑥 36.70 − 52 , 0 = $0 53
 BINOMIAL TREES WITH DIVIDENDS

𝑆0 𝑢 = 50 × 1.1 = $55 𝑒 0.05×0.5 − 0.9

𝑆0′ 𝑢 = 55 − 2 = $53 𝑝= = 0.6266
1.1 − 0.9
$58.30 𝑆𝑜 𝑢𝑢 = 53 × 1.1 = $58.30
$56.30 𝑆0′ 𝑢𝑢 = 58.30 − 2 = $56.30
$55 𝑆0 𝑑 = 50 × 0.9 = $45
𝑓𝑢 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢𝑢 + 1 − 𝑝 × 𝑓𝑢𝑑
$53 $4.30 𝑆0′ 𝑑 = 45 − 2 = $43 = 𝑒 −0.05×0.5 × 0.6266 × 4.30 + 1 − 0.6266 × 0 = $2.6279
𝑆0 𝑑𝑑 = 43 × 0.9 = $38.70
$2.6279 𝑆0′ 𝑑𝑑 = 38.70 − 2 = $36.70 𝑓𝑑 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑑𝑢 + 1 − 𝑝 × 𝑓𝑑𝑑
$50 $47.70 𝑆0 𝑢𝑑 = 53 × 0.9 = $47.70
= 𝑒 −0.05×0.5 × 0.6266 × 0 + 1 − 0.6266 × 0 = $0
$1.61 $45.70 𝑆0′ 𝑢𝑑 = 47.70 − 2 = $45.70
$45 $0 𝑆0 𝑑𝑢 = 43 × 1.1 = $47.30
$43 $0 $47.30 𝑆0′ 𝑑𝑢 = 47.30 − 2 = $45.30 𝑓 = 𝑒 −𝑟𝑇 × 𝑝 × 𝑓𝑢 + 1 − 𝑝 × 𝑓𝑑
= 𝑒 −0.05×0.5 × 0.6266 × 2.6279 + 1 − 0.6266 × 0
$45.30
$0 = $1.6060
𝑓𝑢𝑢 = 𝑚𝑎𝑥 56.3 − 52 , 0 = $4.30
$38.70
$0 $36.70
𝑓𝑢𝑑 = 𝑚𝑎𝑥 45.70 − 52 , 0 = $0
𝑓𝑑𝑢 = 𝑚𝑎𝑥 45.30 − 52 , 0 = $0 A: $1.61
𝑓𝑑𝑑 = 𝑚𝑎𝑥 36.70 − 52 , 0 = $0 54
NEXT STEPS

55
 NEXT STEPS

Homework 2. What is the fair value for a six-month European call

option with a strike price of $135 over a stock which is
1. What is the fair value for a two-year American put trading at $138.15 and has a volatility of 42.5% when
option with a strike price of $85 over a stock which is the risk free rate is 1.85% using the two step binomial
trading at $86.15 which has a volatility of 37% when tree?
the risk free rate is 1.75% using the two step binomial
tree? a) What is the price of the call option?

a) What is the price of the put option? b) What is the delta of this option?

b) What is the delta of this option? c) What is the probability of an up movement in this
stock?
c) What is the probability of a down movement in this
stock? d) What is the probability of a down movement in this
stock?
d) What is the probability of an up movement in this
stock? e) What is the proportional move up for this stock

e) What is the proportional move up for this stock f) What is the proportional move down for this stock

f) What is the proportional move down for this stock g) What would be the value of the put option with the
same strike price?
g) What would be the value of the call option with the
same strike price?
56
 NEXT STEPS

3. Determine the price of a two-year EUROPEAN put option 5. Determine the price of a two-year AMERICAN put option
with a strike price of $53.50 on a stock that is currently with a strike price of $52 on a stock that is currently priced
priced at $50 if the risk free rate was 3.2%? Each year at $48.78 which has a volatility of 46.5%pa if the risk free
there are only two outcomes for this stock, either: rate was 3.2%. After the first year the stock pays a
• A 12% move up, or dividend of $2.15 and after the second year the stock is
• A 12% move down
expected to pay a dividend of $2.32.
After the first year the stock pays a dividend of $2 and after the a) What is the price of this put option?
second year the stock is expected to pay a dividend of $2.10. b) What is the delta of this option?
c) What is the probability of a move up for this stock?
4. What is the fair value for the call option with the same strike
price? d) What is the probability of a move down for this stock?

a) What is the price of the call option? e) What is the fair value for the call option with the same strike
price?
b) What is the delta of this option
f) What is the delta of the call option?
c) What is the probability of a move up for this stock?
g) What is the proportional move up for this stock
d) What is the probability of a move down for this stock?
h) What is the proportional move down for this stock
e) What is the proportional move up in price for this stock?
f) What is the proportional move down for this stock?

57
QUESTIONS