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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Chapter 4: Option Pricing Models:The Binomial Model You can think of a derivative as a mixture of its constituent underliers much as a cake is a mixture of eggs, flour, and milk in carefully specified proportions. The derivative’s model provides a recipe for the mixture, one whose ingredients’ quantities vary with time. Emanuel Derman Risk, July, 2001, p. 48 Important Concepts in Chapter 4 The concept of an option pricing model The one- and two-period binomial option pricing models Explanation of the establishment and maintenance of a risk-free hedge Illustration of how early exercise can be captured The extension of the binomial model to any number of time periods Alternative specifications of the binomial model Definition of a model A simplified representation of reality that uses certain inputs to produce an output or result Definition of an option pricing model A mathematical formula that uses the factors that determine an option’s price as inputs to produce the theoretical fair value of an option. The One-Period Binomial Model Conditions and assumptions One period, two outcomes (states) S = current stock price u = 1 + return if stock goes up d = 1 + return if stock goes down r = risk-free rate Value of European call at expiration one period later Cu = Max(0,Su - X) or Cd = Max(0,Sd - X) See Figure 4.1, p. 98 The One-Period Binomial Model (continued) Important point: d 1 + r u to prevent arbitrage We construct a hedge portfolio of h shares of stock and one short call. Current value of portfolio: V = hS - C At expiration the hedge portfolio will be worth Vu = hSu - Cu Vd = hSd - Cd If we are hedged, these must be equal. Setting Vu = Vd and solving for h gives The One-Period Binomial Model (continued) These values are all known so h is easily computed Since the portfolio is riskless, it should earn the risk-free rate. Thus V(1+r) = Vu (or Vd) Substituting for V and Vu (hS -