Demonstration of Multi-period Binomial Model

Case 1~3 assumes the underlying asset does not pay dividend while Case 4~5 discuss situations with
dividend-paying underlying assets.
Assume the following: 𝑺𝟎 = 𝟏𝟎𝟎, 𝒖 = 𝟏. 𝟐𝟓, 𝒅 = 𝟎. 𝟖, 𝐚𝐧𝐝 𝒓 = 𝟕%

Short Cut to solve for 𝒑:

Since 𝑆0 = 100, we have:
125∗𝑝+80∗(1−𝑝)
100 = ; therefore 𝑝 = 0.6.
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1+0.07−0.8
Alternatively, we can use the formula for 𝒑 𝑝 = = 0.6
1.25−0.8

Case 1: European Call without dividend (𝑿 = 𝟏𝟎𝟎)

125*1.25=156.25
125
𝑆0 = 100 125*0.8 or 80*1.25=100
80
80*0.8=64

𝐶𝑢𝑢 = 56.25
𝑪𝒖 =? ? ?
𝑪𝟎 =? ? ? 𝐶𝑢𝑑 = 𝐶𝑑𝑢 = 0
𝑪𝒅 =? ? ?
𝐶𝑑𝑑 = 0
Therefore
56.25 ∗ 0.6 + 0 ∗ 0.4
𝐶𝑢 = = 31.54
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0∗0.6+0∗0.4
𝐶𝑑 = = 0;
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(Note that both 𝑪𝒖 and 𝑪𝒅 is at least equal to their respective intrinsic values ($25 and $0). So we will
not have an early exercise for an American call without dividend)
31.54∗0.6+0∗0.4
 𝐶0 = = 17.69
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Note that the hedge ratio will change when the underlying moves into different state in the future:
31.54−0
The hedge ratio initially (ℎ0 ) = = 0.7009;
125−80

56.25−0
The hedge ratio if upstate happens at the end of 1st period (ℎ1,𝑢 ) = 156.25−100 = 1;

0−0
The hedge ratio if downstate happens at the end of 1st period (ℎ1,𝑑 ) = 100−64 = 0
Case 2: European Put without dividend (𝑿 = 𝟏𝟎𝟎)

125*1.25=156.25
125
𝑆0 = 100 125*0.8 or 80*1.25=100
80
80*0.8=64

𝑃𝑢𝑢 = 0
𝑷𝒖 =? ? ?
𝑷𝟎 =? ? ? 𝑃𝑢𝑑 = 𝑃𝑑𝑢 = 0
𝑷𝒅 =? ? ?
𝑃𝑑𝑑 = 36
Therefore
0 ∗ 0.6 + 0 ∗ 0.4
𝑃𝑢 = =0
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0∗0.6+36∗0.4
𝑃𝑑 = = 13.46; as you can see, at this time, 𝑃𝑑 will be smaller than its intrinsic value ($20) and
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this suggests that the time value of the put will become negative at the end of 1 st period if we have a
downstate in the 1st period!
0∗0.6+13.46∗0.4
 𝑃0 = = 5.03
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Note that the hedge ratio will change when the underlying moves into different state in the future:
13.46−0
The hedge ratio initially (ℎ0 ) = = 0.2991;
125−80

0−0
The hedge ratio if upstate happens at the end of 1st period (ℎ1,𝑢 ) = 156.25−100 = 0;

36−0
The hedge ratio if downstate happens at the end of 1st period (ℎ1,𝑑 ) = =1
100−64
Case 3: American Put without dividend (𝑿 = 𝟏𝟎𝟎)

125*1.25=156.25
125
𝑆0 = 100 125*0.8 or 80*1.25=100
80
80*0.8=64

𝑃𝑢𝑢 = 0
𝑷𝒖 =? ? ?
𝑷𝟎 =? ? ? 𝑃𝑢𝑑 = 𝑃𝑑𝑢 = 0
𝑷𝒅 =? ? ?
𝑃𝑑𝑑 = 36
Therefore
𝑃𝑢 = 𝑀𝑎𝑥(𝐸𝑎𝑟𝑙𝑦 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒, 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐾𝑒𝑒𝑝𝑖𝑛𝑔 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑎𝑙𝑖𝑣𝑒)
0 ∗ 0.6 + 0 ∗ 0.4
= Max(0, )=0
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𝑃𝑑 = 𝑀𝑎𝑥(𝐸𝑎𝑟𝑙𝑦 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒, 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐾𝑒𝑒𝑝𝑖𝑛𝑔 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑎𝑙𝑖𝑣𝑒)
0∗0.6+36∗0.4
= 𝑀𝑎𝑥(20, ) = 20; as you can see, we will have a rational (optimal) early exercise when we
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have a downstate in the 1st period!

 𝑃0 = 𝑀𝑎𝑥(𝐸𝑎𝑟𝑙𝑦 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒, 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐾𝑒𝑒𝑝𝑖𝑛𝑔 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑎𝑙𝑖𝑣𝑒)
0∗0.6+20∗0.4
= Max(0, ) = 7.4766; we do not have an early-exercise possibility at time 0.
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Note this indicates that American Put worth more than European Put when there is a possibility for a
rational early-exercise before maturity.
The above also shows that it may be optimal for a deep-in-the-money American put holders to early
exercise their options before maturity.
Case 4: European Call (𝑿 = 𝟏𝟎𝟎)
with 10% dividend yield at 1st period for which option holders are not protected

112.5*1.25=140.625
125(CUM) or 112.5 (EX)
𝑆0 = 100 112.5*0.8 or 72*1.25=90
80 (CUM) or 72 (EX)

72*0.8=57.6

𝐶𝑢𝑢 = 40.625
𝑪𝒖 =? ? ?
𝑪𝟎 =? ? ? 𝐶𝑢𝑑 = 𝐶𝑑𝑢 = 0
𝑪𝒅 =? ? ?
𝐶𝑑𝑑 = 0
Therefore
40.625 ∗ 0.6 + 0 ∗ 0.4
𝐶𝑢 = = 22.78
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0 ∗ 0.6 + 0 ∗ 0.4
𝐶𝑑 = =0
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22.78∗0.6+0∗0.4
 𝐶0 = = 12.77
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Note that the non-protection feature results in a lower value for the European call, compared to the case
when there is no dividend paid before maturity ($17.69 on page 1)
Case 5: American Call (𝑿 = 𝟏𝟎𝟎)
with 10% dividend yield at 1st period for which option holders are not protected

112.5*1.25=140.625
125(CUM) or 112.5 (EX)
𝑆0 = 100 112.5*0.8 or 72*1.25=90
80 (CUM) or 72 (EX)

72*0.8=57.6

𝐶𝑢𝑢 = 40.625
𝑪𝒖 =? ? ?
𝑪𝟎 =? ? ? 𝐶𝑢𝑑 = 𝐶𝑑𝑢 = 0
𝑪𝒅 =? ? ?
𝐶𝑑𝑑 = 0
Therefore
𝐶𝑢 = 𝑀𝑎𝑥(𝐸𝑎𝑟𝑙𝑦 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒, 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐾𝑒𝑒𝑝𝑖𝑛𝑔 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑎𝑙𝑖𝑣𝑒)
40.625∗0.6+0∗0.4
= Max (25, ) = 𝑀𝑎𝑥(25, 22.78) = 25; as you can see, we will have a rational (optimal)
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early exercise when we have a upstate in the 1st period!

𝐶𝑑 = 𝑀𝑎𝑥(𝐸𝑎𝑟𝑙𝑦 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒, 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐾𝑒𝑒𝑝𝑖𝑛𝑔 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑎𝑙𝑖𝑣𝑒)
0 ∗ 0.6 + 0 ∗ 0.4
= Max(0, )=0
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 𝐶0 = 𝑀𝑎𝑥(𝐸𝑎𝑟𝑙𝑦 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒, 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐾𝑒𝑒𝑝𝑖𝑛𝑔 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 𝑎𝑙𝑖𝑣𝑒)
25∗0.6+0∗0.4
= Max(0, ) = 14.02; we do not have an early-exercise possibility at time 0.
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Note that the non-protection feature still results in a lower value for the American call, compared to the
case when there is no dividend paid before maturity ($17.69 on page 1). But American call is still worth
more than the European Call ($12.77 on page 4) when there is a non-protected dividend paid by the
underlying asset.