BinomialModel_1Period.pdfVIP

Financial Engineering Risk Management Option Pricing and the Binomial Model M. Haugh G. Iyengar Department of Industrial Engineering and Operations Research Columbia University A Brief Overview of Option Pricing In the next series of modules we’ll study: 1. The 1-period binomial model 2. The multi-period binomial model 3. Replicating strategies 4. Pricing European and American options in the binomial lattice 5. The Black-Scholes formula 2 Stock Price Dynamics in the Binomial Model         PPPPPPPPPPPPPPPPP PPPPPPPPPPP      PPPPPP    t = 0 t = 1 t = 2 t = 3 100 107 114.49 122.5 100 107 93.46 93.46 87.34 81.63 A risk-free asset or cash account also available - $1 invested in cash account at t = 0 worth Rt dollars at time t 3 Some Questions 1. How much is an option that pays max(0, S3 ? 100) at t = 3 worth? (i) do we have enough information to answer this question? (ii) should the price depend on the utility functions of the buyer and seller? (iii) will the price depend on the true probability, p, of an up-move in each period? Perhaps the price should be EP0[R?3 max(0, S3 ? 100)]? (1) 2. Suppose now that: (i) you stand to lose a lot at date t = 3 if the stock is worth 81.63 (ii) you also stand to earn a lot at date t = 3 if the stock is worth 122.49. If you don’t want this risk exposure could you do anything to eliminate it? 4 The St. Petersberg Paradox Consider the following game - a fair coin is tossed repeatedly until first head appears - if first head appears on the nth toss, then you receive $2n How much would you be willing to pay in order to play this game? The expected payoff is given by EP0[Payoff] = ∞∑ n=1 2n P(1st head on nth toss) = ∞∑ n=1 2n 12n = ∞ But would you pay an infinite amount of money to play this game? - clear then that (1) does not give correct option price. 5 The St. Petersberg Paradox Daniel Bernouilli resolved this paradox by introducing a utility function, u(·) - u(x) measures how much utility or benefit y