1. Chapter 12 Binomial Trees
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

2. A Simple Binomial Model
A stock price is currently 100
In 12 months it will be either 110 or 95
Stock Price = 110
Stock price = 100
Stock Price = 95

3. A Call Option
A 12-month call option on the stock has a strike price of 100. Risk-free rate of return is 5 % p.a.
Stock Price = 110
Option Price = 10
Stock price = 100
Option Price=?
Stock Price = 95
Option Price = 0

4. Setting Up a Riskless Portfolio
Consider the Portfolio: long D shares short 1 call option
Portfolio is riskless when 110D – 10 = 95D or
D = 2/3
110D – 10
95D

5. Valuing the Portfolio (Risk-free rate is 5%)
The riskless portfolio is:
long 2/3 shares short 1 call option
The value of the portfolio in 12 months is x 2/3 – 10 = 63 1/3
The value of the portfolio today is / 1.05 = 60.32

6. Valuing the Option The portfolio that is
long 2/3 shares short 1 option
is worth 60.32
The value of the shares is (= 2/3 ´ 100 )
The value of the option is therefore (= – )

7. Generalization
Consider the portfolio that is long D shares and short 1 derivative
The portfolio is riskless when DSu – Cu = DSd – Cd or
DSu – Cu
DSd – Cd

8. Generalization
Method 2: Pay-off of call option can be replicated by buying D stocks and borrowing money for that. The amount of debt (B) needed for long position can be determined as follows:

9. Valuing a Call Option
100 C0
104.88
97.47
110 10
102.23
2.23 95 C2 C1

10. A Simple Binomial Model
A stock price is currently $20
In 3 months it will be either $22 or $18
Stock Price = $18
Stock Price = $22
Stock price = $20
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

11. A Call Option (Figure 12.1, page 254)
A 3-month call option on the stock has a strike price of 21.
Stock Price = $22
Option Price = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Price = $0
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

12. Setting Up a Riskless Portfolio
For a portfolio that is long D shares and a short 1 call option values are
Portfolio is riskless when 22D – 1 = 18D or D = 0.25
22D – 1
18D
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

13. Valuing the Portfolio (Risk-Free Rate is 12%)
The riskless portfolio is:
long 0.25 shares
short 1 call option
The value of the portfolio in 3 months is
22 ×0.25 – 1 = 4.50
The value of the portfolio today is
4.5e–0.12×0.25 =
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

14. Valuing the Option The portfolio that is long 0.25 shares
short 1 option
is worth 4.367
The value of the shares is (= 0.25 × 20 )
The value of the option is therefore
0.633 ( – = )
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

15. Generalization (Figure 12.2, page 255)
A derivative lasts for time T and is dependent on a stock
S0u ƒu
S0d ƒd S0 ƒ
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

16. Generalization (continued)
Value of a portfolio that is long D shares and short 1 derivative:
The portfolio is riskless when S0uD – ƒu = S0dD – ƒd or
S0uD – ƒu
S0dD – ƒd
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

17. Generalization (continued)
Value of the portfolio at time T is S0uD – ƒu
Value of the portfolio today is (S0uD – ƒu)e–rT
Another expression for the portfolio value today is S0D – f
Hence
ƒ = S0D – (S0uD – ƒu )e–rT
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

18. Generalization (continued)
Substituting for D we obtain
ƒ = [ pƒu + (1 – p)ƒd ]e–rT
where
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

19. p as a Probability S0u ƒu p S0 ƒ S0d (1 – p ) ƒd
It is natural to interpret p and 1-p as probabilities of up and down movements
The value of a derivative is then its expected payoff in a risk-neutral world discounted at the risk-free rate
S0u ƒu
S0d ƒd S0 ƒ p
(1 – p )
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

20. Risk-Neutral Valuation
When the probability of an up and down movements are p and 1-p the expected stock price at time T is S0erT
This shows that the stock price earns the risk-free rate
Binomial trees illustrate the general result that to value a derivative we can assume that the expected return on the underlying asset is the risk-free rate and discount at the risk-free rate
This is known as using risk-neutral valuation
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

21. Original Example Revisited
p is the probability that gives a return on the stock equal to the risk-free rate:
20e 0.12 ×0.25 = 22p + 18(1 – p ) so that p =
Alternatively:
S0u = 22
ƒu = 1
S0d = 18
ƒd = 0
S0=20 ƒ p
(1 – p )
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

22. Valuing the Option Using Risk-Neutral Valuation
The value of the option is e–0.12×0.25 (0.6523× ×0) = 0.633
S0u = 22
ƒu = 1
S0d = 18
ƒd = 0
S0=20 ƒ
0.6523
0.3477
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

23. Irrelevance of Stock’s Expected Return
When we are valuing an option in terms of the price of the underlying asset, the probability of up and down movements in the real world are irrelevant
This is an example of a more general result stating that the expected return on the underlying asset in the real world is irrelevant
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

24. A Two-Step Example Figure 12.3, page 260
K=21, r = 12%
Each time step is 3 months 20 22 18
24.2
19.8
16.2
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

25. Valuing a Call Option Figure 12.4, page 260
Value at node B = e–0.12×0.25(0.6523× ×0) = Value at node A = e–0.12×0.25(0.6523× ×0) =
16.2
0.0 20
1.2823 22 18
24.2
3.2
19.8
2.0257 A B
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

26. A Put Option Example Figure 12.7, page 26350
4.1923 60 40 72 48 4 32 20
1.4147
9.4636
K = 52, time step =1yr r = 5%, u =1.32, d = 0.8, p =
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

27. What Happens When the Put Option is American (Figure 12.8, page 264)50
5.0894 60 40 72 48 4 32 20
1.4147
12.0 C
The American feature increases the value at node C from to
This increases the value of the option from to
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

28. Delta
Delta (D) is the ratio of the change in the price of a stock option to the change in the price of the underlying stock
The value of D varies from node to node
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

29. Choosing u and d
One way of matching the volatility is to set where s is the volatility and Dt is the length of the time step. This is the approach used by Cox, Ross, and Rubinstein
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

30. Girsanov’s Theorem
Volatility is the same in the real world and the risk-neutral world
We can therefore measure volatility in the real world and use it to build a tree for the an asset in the risk-neutral world
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

31. Assets Other than Non-Dividend Paying Stocks
For options on stock indices, currencies and futures the basic procedure for constructing the tree is the same except for the calculation of p
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

32. The Probability of an Up Move
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012