Chapter 11
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.1
A Simple Binomial Model
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.2
A Call Option (Figure 11.1, page 242)
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.3
Setting Up a Riskless Portfolio
l Consider the Portfolio: long ∆ shares
short 1 call option
22∆ – 1
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.4
Valuing the Portfolio
(Risk-Free Rate is 12%)
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.5
Valuing the Option
l The portfolio that is
long 0.25 shares short
1 option
is worth 4.367
l The value of the shares is
5.000 (= 0.25 × 20 )
l The value of the option is therefore
0.633 (= 5.000 – 4.367 )
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.6
Generalization (Figure 11.2, page 243)
S0u
ƒu
S0
ƒ S0d
ƒd
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.7
Generalization
(continued)
S0u∆ – ƒu
l
l 0d∆ ––ƒƒ
The portfolio is riskless when SS0u∆ u d= S0d∆ – ƒd or
ƒu − f d
∆=
S 0u − S 0 d
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.8
Generalization
(continued)
where
e −d rT
p=
u −d
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.10
p as a Probability
S0u
p ƒu
S0
ƒ ( S0d
1 –
p) ƒd
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.11
Risk-neutral Valuation
l When the probability of an up and down
movements are p and 1-p the expected stock
price at time T is S0erT
l This shows that the stock price earns the risk-
free rate
l 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
l This is known as using risk-neutral valuation
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.12
Original Example Revisited
S0u = 22
p ƒu = 1
S0
l
ƒ
Since p is the probability that gives a return on18
the
l
( S d =
1 – rate. We can find it
0
stock equal to the risk-free
from p) ƒd = 0
20e0.12 × 0.25 = 22p + 18(1 – p )
which gives p = 0.6523
l Alternatively, we can use the formula
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.13
Valuing the Option Using Risk-
Neutral Valuation
S0u = 22
52 3 ƒu = 1
0.6
S0
ƒ
0.34 S0d = 18
77
The value of the option is ƒd = 0
e–0.12 × 0.25 (0.6523× 1 + 0.3477× 0)
= 0.633
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.14
Irrelevance of Stock’s Expected
Return
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.15
A Two-Step Example
Figure 11.3, page 246
24.2
22
20 19.8
l Each time step is 3 months
l K=21, r=12%18
16.2
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.16
Valuing a Call Option
Figure 11.4, page 247
24.2
D
3.2
22
B
20 2.0257 19.8
A E 0.0
1.2823 –0.12
l Value at node B 18 =e
× 0.25 (0.6523× 3.2 + 0.3477× 0)C= 2.0257
0.0 16.2
–0.12
l Value at node A F= e 0.0
× 0.25 (0.6523× 2.0257 + 0.3477× 0)
= 1.2823
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.17
A Put Option Example; K=52
Figure 11.7, page 250
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.18
What Happens When an Option is
American (Figure 11.8, page 251)
72
D
0
60
B
50 1.4147 48
A E 4
5.0894
40
C
12.0 32
F 20
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.19
Delta
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Choosing u and d
One way of matching the volatility is to
set
u =e σ ∆t
d =1 u =e −σ ∆t
a−d
p=
u−d
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.22