3 Tree Models for stock and Options.ppt

* Chapter 3 Tree Models for Stocks and Options §1. A Stock Model As before, our stock can move to only one of two prices over one unit of time. Let S0 = Stock price at time t = 0 where where the stock parameters, u, d, and p, are given. We consider a repeated binomial tree of the stock. Figure 3.1 Stock price tree Stock Value Probability Denote the stock price at time t by St, then It is easy to obtain that 1.1 Recombing Trees The compressed stock tree is Time t = 0 1 2 3 Our ultimate goal is to use such tree to price options and derivatives and to describe the behavior of portfolios. The problem: Can we use the compressed stock tree to find E(S3), for example? 1.2 Chaining and Expected Values t = 0 1 2 3 The entry of each node has the form: Sol. Construct the price tree for our stock model. § 2. Pricing a European Option with the Tree Model Example 1. Assume The call option expires at t = 3. What is a fair price for the call option today? Time t = 0 1 2 3 Draw the option tree, but we put in only the values for t = 3. Time t = 0 1 2 3 In the following, we use chaining to fill the blanks in the tree. Suppose we are faced with the subtree as follows: Then Returning to the immediate example, we have Sol. Construct the price tree for our stock model. Classwork 1. Assume The put option expires at t = 3. What is a fair price for the derivative today? Time t = 0 1 2 3 Returning to the immediate example, we have Homework 1. Ex 2, Page 45 Ex 3, Page 49 §3 Pricing an American Option An American option can be exercised at any time piror to it