American option pricing using Binomial trees

In this section, we study to price American option using Binomial trees.

Example
Consider a five-month American put option on a non-dividend-paying
stock when the stock price is 50, the risk-free interest rate is 10% per annum,
= 11224 and = 08909. With our usual notation, this means that
5
04167. Suppose that we divide the
0 = 50 = 50 = 01 and = 12
life of the option into five intervals of length one month (= 00833 year, i.e.
04167
0083 3) for the purposes of constructing a Binomial tree. Calculate
5
the theoretical American put option premium using Binomial trees.
Solution
From the data given, we have
0100833 08909

=

11224 08909
= 05073

1 = 04927

European Put Option

Stock Price
Option Price

89.07

0.00
79.35

0.00
70.70

70.70

0.00

0.00

62.99

(0.5073 0
+0.4927 1.30)
e0.100.0833
= 0.64

50
(0.5073 2.12
+0.4927 6.66)
e0.100.0833 = 4.32

62.99

0.00

56.12

56.12

(0.5073 0.64
+0.4927 3.67)
e0.100.0833 = 2.12

(0.5073 0
+0.4927 2.66)
e0.100.0833 = 1.30

44.55

(0.5073 3.67
+0.4927 9.86)
e0.100.0833 = 6.66

50
(0.5073 1.30
+0.4927 6.18)
e0.100.0833 = 3.67

39.69

(0.5073 6.18
+0.4927 13.82)
e0.100.0833 = 9.86

44.55

56.12

0.00
50
(0.5073 0
+0.4927 5.45)
e0.100.0833 = 2.66

(0.5073 2.66
+0.4927 9.90)
e0.100.0833 = 6.18

39.69

35.36

(0.5073 5.45
+0.4927 14.64)
e0.100.0833 = 9.90

44.55
5.45

(0.5073 9.90
+0.4927 18.08)
e0.100.0833 = 13.82

35.36

14.64
31.50

(0.5073 14.64
+0.4927 21.93)
e0.100.0833 = 18.08

28.07

21.93
Node Time
0.0000

0.0833

0.1667

0.2500

0.3333

0.4167

American Put Option

Stock Price
Option Price

89.07
0.00
79.35
0.00
70.70
0.00
62.99
0.64
56.12

50
(0.5073 2.16
+0.4927 6.96)
e0.100.0833 = 4.49

(0.5073 0.64
+0.4927 3.77)
e0.100.0833 = 2.16

50

44.55

(0.5073 1.30
+0.4927 6.38)
e0.100.0833 = 3.77

(0.5073 3.77
+0.4927 10.36)
e0.100.0833 = 6.96,
Then, Max(50 44.55
= 5.45, 6.96)
= 6.96

70.70
0.00
62.99
0.00

56.12
(0.5073 0
+0.4927 2.66)
e0.100.0833 = 1.30

56.12
0.00

50
2.66
44.55
(0.5073 2.66
+0.4927 10.31)
e0.100.0833 = 6.38.
Then, Max(50 44.55
= 5.45, 6.38)
= 6.38

39.69
(0.5073 6.38
+0.4927 14.64)
e0.100.0833 = 10.36,
Then, Max(50 39.69
= 10.31, 10.36)
= 10.36

44.55
5.45

39.69
Max(50 39.69 = 10.31,
9.90) =10.31

35.36
(0.5073 10.31
+0.4927 18.50)
e0.100.0833 = 14.23.
Then, Max(50 35.36
= 14.64, 14.23)
=14.64

35.36
14.64

31.50
Max(50 31.50 = 18.50,
18.08) =18.50
28.07

21.93
Node Time
0.0000

0.0833

0.1667

0.2500

0.3333

0.4167

indicates where the option can be exercised. Therefore we have

American Put Option Premium
European Put Option Premium

=
=

4.49,
4.32.

So the cost of early exercise provision on the American Put at time 0 is given by
4.49 4.32 = 0.17.

Exotic options pricing using Binomial trees

Derivatives with more complicated payos than the standard European/American
calls and puts are referred to as exotic options (standard options are called
vanilla options).
Most exotic options trade in the over-the-counter (OTC) market and
have been designed to meet particular needs of corporations.
Examples of exotic options are Binary (Digital) option, Chooser option,
Lookback options, Asian option and Barrier option.
In this section, we study to price Lookback options, Asian option and
Barrier option using Binomial trees. We will look at how to price two
other exotic options, i.e. Binary (Digital) option and Chooser option in
ACST307/817 based on continuous time framework.

1. Lookback options
The payos from lookback options depend on the maximum or minimum stock price reached during the life of the option. The payo from
a European-style floating strike lookback call is the amount that the final
stock price exceeds the minimum stock price achieved during the life of the
option. The payo from a European-style floating strike lookback put is
the amount by which the maximum stock price achieved during the life of
the option exceeds the final option price.
A floating strike lookback call is a way that the holder can buy the
underlying asset at the lowest price achieved during the life of the option.
Similarly, a floating strike lookback put is a way that the holder can sell the
underlying asset at the highest price achieved during the life of the option.
The underlying asset in a lookback option is often a commodity.
Fixed strike lookback option
The payo of a fixed strike lookback call option at maturity is given by

where 0 = max { : 0 }

And the payo of a fixed strike lookback put option at maturity is given
by
+

where 0 = min { : 0 }.

Floating strike lookback option

The payo of a floating strike lookback call option at maturity is given
by
+

where 0 = min { : 0 }

And the payo of a floating strike lookback put option at maturity is

given by
+

where 0 = max { : 0 }.

Example
Consider a three-month European option on a non-dividend-paying stock
when the stock price is 50, the risk-free interest rate is 10% per annum, and
the volatility is 40% per annum. With our usual notation, this means that
0 = 50 = 50 = 01 = 11224, = 08909 and = 025. Suppose
that we divide the life of the option into three intervals of length one month
(=0.0833 year) for the purposes of constructing a Binomial tree. Calculate
the theoretical fixed strike lookback call option premium using Binomial
trees.
Solution
From the data given, we have

0100833 08909
=

11224 08909
= 05073

1 = 04927

Fixed Strike Lookback Call Option

Stock Price
Vanilla Option Price
G
70.70
20.70

A
50
(0.5073 8.25
+0.4927 1.55)
e0.100.0833 = 4.91

B
56.12
(0.5073 13.40
+0.4927 3.08)
e0.100.0833 = 8.25

C
44.55
(0.5073 3.08
+0.4927 0)
e0.100.0833 = 1.55

D
62.99
(0.5073 20.70
+0.4927 6.12)
e0.100.0833 = 13.40
H
56.12
6.12
E
50
(0.5073 6.12
+0.49276 0)
e0.100.0833 = 3.08
I
44.55
0
F
39.69
0
J
35.36
0

Node Time
0.0000

0.0833

0.1667

0.2500

The payo of a fixed strike lookback call option at maturity is given by

+
T
S0 K ,

where S 0 = max {St : 0 t T } .

At time t = 0.25, the option payo is
Path
ABDG
ABDH
ABEH
ABEI
ACEH
ACEI
ACFI
ACFJ

max St

0tT

70.70
62.99
56.12
56.12
56.12
50
50
50

K
50
50
50
50
50
50
50
50

max St K

0tT

20.70
12.99
6.12
6.12
6.12
0
0
0

At time t = 0.1667:
ABD
CD
ABE
CE
ACE
CE
CFACF

=
=
=
=

e0.083330.1 (20.70 0.5073 + 12.99 0.4927) = 16.761,

e0.083330.1 (6.12 0.5073 + 6.12 0.4927) = 6.0692,
e0.083330.1 (6.12 0.5073 + 0 0.4927) = 3.0789,
e0.083330.1 (0 0.5073 + 0 0.4927) = 0.

At time t = 0.0833:
CB
CC

= e0.083330.1 (16.761 0.5073 + 6.0692 0.4927) = 11.3978,

= e0.083330.1 (3.0789 0.5073 + 0 0.4927) = 1.5489.

Finally at time t = 0:
CA = e0.083330.1 (11.3978 0.5073 + 1.5489 0.4927) = 6.4909.
Vanilla call option price is 4.91. If we find the vanilla put option price, it is given by 3.67. Fixed strike
lookback call option price is 6.4909. It is 32.2% higher than vanilla call option price and 43.2% higher than
vanilla put option price.

Both types of lookback options are more expensive than vanilla options. So to reduce the price, the following lookback options are released.
Fixed strike partial lookback option
The payo of a fixed strike partial lookback call option at maturity is
given by

where = max { : 0 } i.e. the last part of the options life.

Floating strike partial lookback option
The payo of a floating strike partial lookback call option at maturity is
given by

where 0 = min { : 0 } i.e. the first part of the options life.

Fixed strike fractional lookback option
The payo of a fixed strike fractional lookback call option at maturity is
given by

where 0 = max { : 0 } and 0 1.

2. Asian options
Asian options are options where the payo depends on the average price
of the underlying asset during at least some part of the life of the option.
Asian options are popular in situations where the underlying asset is
thinly traded or there is the potential for its price to be manipulated, as
Asian option oers some protection. It is more dicult to manipulate the
average value of an underlying asset over an extended period of time than
it is to manipulate it just at the expiration of an option. Asian options are
also attractive as they are less expensive than vanilla options.

There are two types of average, i.e.

Discrete geometric average:

=0

Discrete arithmetic average:

1
+1

1
+1

!

X

=0

Fixed strike Asian option

The payo of a fixed strike Asian call option at maturity is given by
+

0

And the payo of a fixed strike Asian put option at maturity is given by

+
0
Floating strike Asian option
The payo of a floating strike Asian call option at maturity is given by

+
0

And the payo of a floating strike Asian put option at maturity is given
by

+
0
Example
Consider a Binomial tree for the stock price { : = 0 1 2 3}. Let
0 = 50 = 11224 and = 08909. Assume also that the risk-free rate is
10% per annum. Price an arithmetic Asian call option written on with
= 50 and maturity at time 3 months.
Solution
The parameter values needed are

0100833 08909

=

11224 08909
= 05073

1 = 04927

Fixed strike arithmetic Asian call option

Stock Price
Vanilla Option Price
G
70.70
20.70

A
50
(0.5073 8.25
+0.4927 1.55)
e0.100.0833 = 4.91

B
56.12
(0.5073 13.40
+0.4927 3.08)
e0.100.0833 = 8.25

C
44.55
(0.5073 3.08
+0.4927 0)
e0.100.0833 = 1.55

D
62.99
(0.5073 20.70
+0.4927 6.12)
e0.100.0833 = 13.40
H
56.12
6.12
E
50
(0.5073 6.12
+0.49276 0)
e0.100.0833 = 3.08
I
44.55
0
F
39.69
0
J
35.36
0

Node Time
0.0000

0.0833

0.1667

0.2500

The payo of a fixed strike Asian call option at maturity is given by

+

(A K)
where
1
A=
T +1

T !
X
Si .
i=0

At time t = 3, the option payo is

Path
ABDG
ABDH
ABEH
ABEI
ACEH
ACEI
ACFI
ACFJ

50+56.12+62.99+70.70
4
50+56.12+62.99+56.12
4
50+56.12+50+56.12
=
4
50+56.12+50+44.55
=
4
50+44.55+50+56.12
=
4
50+44.55+50+44.55
=
4
50+44.55+39.69+44.55
4
50+44.55+39.69+35.36
4

= 59.953
= 56.308
53.06
50.168
50.168
47.275
= 44.698
= 42.4

K
50
50
50
50
50
50
50
50

(A K)+
9.953
6.308
3.06
0.168
0.168
0
0
0

At time t = 2:
ABD
CD
ABE
CE
ACE
CE
CFACF

=
=
=
=

e0.100.0833 (9.953 0.5073 + 6.308 0.4927) = 8.0894,

e0.100.0833 (3.06 0.5073 + 0.168 0.4927) = 1.6215,
e0.100.0833 (0.168 0.5073 + 0 0.4927) = 0.084519,
e0.100.0833 (0 0.5073 + 0 0.4927) = 0.

At time t = 1:
CB
CC

= e0.100.0833 (8.0894 0.5073 + 1.6215 0.4927) = 4.8620,

= e0.100.0833 (0.084519 0.5073 + 0 0.4927) = 0.042521

Finally at time t = 0:
CA = e0.100.0833 (4.8620 0.5073 + 0.042521 0.4927) = 2.4668.
Vanilla call option price is 4.91. Fixed strike arithmetic Asian call option price is 2.4668 so it is less
expensive than vanilla call option contract.

3. Barrier options
Barrier options are options where the payo depends on whether the
underlying assets price reaches a certain level during a certain period of
time.
A number of dierent types of barrier options regularly trade in the overthe-counter market. They are attractive to some market participants because they are less expensive than the corresponding regular options. These
barrier options can be classified as either knock-out options or knock-in options. A knock-out option cease to exist when the underlying asset price
reaches a certain barrier; a knock-in option comes into existence only when
the underlying asset price reaches a barrier.
Question
Consider a binomial model with parameters = 12 = 09 = 011
which is the risk free rate of interest per period continuously compounded
and 0 = 60.
(i) Construct a binomial tree up to = 3 (i.e. there are 3 periods) with
the above model specifications.
(ii) Price a standard European call option with expiry = 3 and strike
= 60
(iii) Price a contract with payout at = 3

3
1 X
70

4
=0

(iv) An investment bank oers the following product having the features
below:
(a) If the value of the stock has crossed the level 80 before or on time
= 3, then the contract holder has the right to obtain the dierence between
the value of the stock at time = 3 and 60;
(b) If the value of the stock stayed below the level 80 until (and inclusive)
time = 3, then the contract holder has the right to obtain the dierence
between the value of the stock at time = 3 and 60;
The bank prices this product at 9.99.
price of the product?
7

Is this the fair (arbitrage-free)