Exercise 1: Pricing options with the binomial model
1.
Converting risk free rate and volatility over the length of the period.
The continuously compounded risk free rate was first converted to annualized effective rate and then to the period risk free rate as follows: Interest rate:
Risk-free rate annualized = e Risk free-rate continuously compounded - 1 Risk-free rate annualized = e 0.05- 1 = 5.127110 % Risk-free rate period = Risk-free rate annualized * Risk-free rate period = 5.127110 % * = 0.0393 %
In case of the period risk free rate, the entire month of February (28 days) was divided by the initial number of periods (10) in order to determine the period length (2.8 days) and afterwards, the period length was divided by the number of days in a calendar year (365 days). Volatility:
Volatility period = Volatility annual * Volatility period = 25 % * = 2.22718 %
In case of the period volatility, we first had to subtract the weekends from the month of February in order to get the number of trading days (20) and then we divided by the number of periods (10) to obtain the period length (2 days). The trading year with 252 days was used in order to determine the period volatility.
2.
Size of U-step and D-steps
The calculation for the U-step and D-step can be found in the Excel file, in the Binomial model spreadsheet. The formulas provided in the assignment were used in the calculations, taking into account the different period lengths for the risk-free rate and volatility.
3.
Comparison between Black-Scholes and Binomial Option Values
See the plot of convergence Excel spreadsheet.
4.
Plot of convergence
Periods 1 2 3 4 5 6 7 8 9 10
Binomial call value 1.441805 1.058862 1.286991 1.130527 1.258225 1.158725 1.247569 1.174459 1.242669 1.184838
Black-Scholes call 1.1809 1.1809 1.1809 1.1809 1.1809 1.1809 1.1809 1.1809 1.1809 1.1809
1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1 2 3 4 5 6 7 8 9 10 Binomial call BS call
In addition to the required plot, we wanted to see how the binomial call values approaches the Black-Scholes value as the number of periods increase up to and including 100. A VBA model was developed in order to accomplish this task. In order to see the VB code, the VB add-in must be installed in Excel. This model uses the same intuition as for the 9-period model, the only difference being that code and not formulas was used to obtain it. In addition, Macros have to be enabled for the program to work. The code can be seen by clicking the Developer tab, then the Visual Basic button and then selecting Module 2. The function BinOptionValue can be found at the bottom of Module 2. After running the model and creating the plot, we can observe that as the number of periods increase, the call value gets increasingly closer to the Black-Scholes call value. However, the marginal approach of the Binomial to Black-Scholes call values is decreasing as the number of periods gets larger and larger. After a certain number of periods, the Binomial call value starts to flatten out and doesnt appear to approach the Black-Scholes value at the rate it had for a smaller number of periods.
1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96 Black-Scholes Binomial Call
Exercise 2: Delta-Hedging
1. The table with the computed values can be found in the Excel file, in the Delta Hedging in Binomial Model spreadsheet.
2.
Interpreting the results
The steps taken in each node imply shorting 100 calls, thus getting 100 premiums and buying 100 stocks according to the delta. However we need to borrow the difference between the stock and the call premium. This defines a self financing portfolio because the bond and call perfectly finance the purchase of stocks. Thus net cash flow is 0 each period. In the last node we close the position which means that we sell 100 stocks at the price in that period and pay back the value of the bond and the interest.
3.
The table with the computed values can be found in the Excel file, in the Delta Hedging w B-S spreadsheet.
4.
Interpreting the results
In this case, we extract the delta and call price information using the calculator provided in Black-Scholes spreadsheet. As compared to the previous Delta-Hedging strategy, in this situation the hedge is not perfectly self financing due to presence of uncertainty in the movement of the stock price (the upward and downward factors are uncertain). In the binomial we had a clearly defined path. As such, the DeltaHedge is unable to completely eliminate the variance in the cash position. From the results, we end up with a net cash flow of 0.50.
