Chapter 5 Pricing options from around the world

5.1 An algorithm to price any derivative asset

This algorithm allows us to price any derivative asset via its hedging portfolio. Suppose we have an asset with $X_T(\omega)$, which is measurable with respect to $\mathcal{F}_T$.

First, we define $T$ random variables, $X_{T-1}, \dots, X_1, X_0$, on our probability space, using the recursive formula \[ X_t( \cdots \omega_t) = \frac{1}{1+r} \big( q_u X_{t+1} (\cdots \omega_t 1) + q_d X_{t+1} (\cdots \omega_t 0) \big). \] Here $q_u$ and $q_d$ are the martingale probabilities at each node, given by \[ q_u = \frac{1+r-d}{u-d}, \quad q_d = \frac{u-(1+r)}{u-d}.\]

Next, we let \[ y_t (\cdots \omega_{t-1}) = \frac{ X_t(\cdots \omega_{t-1} 1) - X_t(\cdots \omega_{t-1}0) }{ S_t (\cdots \omega_{t-1} 1) - S_t(\cdots \omega_{t-1} 0)}, \quad t = 1 \dots T. \]

Finally, set $V_0 = X_0$ for all $\omega \in \Omega_T$. Now, for $t = 0, \dots, T-1$, let \[ \quad\quad V_{t+1} =y_{t+1}S_{t+1}+(1+r)(V_t-y_{t+1}S_t). \quad\quad\quad(\textbf{Wealth Equation}) \]

Theorem 5.1 The portfolio given by $y_t(\cdots \omega_{t-1})$ as defined above, with \[ x_t(\cdots \omega_{t-1}) = \frac{ V_{t-1}(\cdots \omega_{t-1}) - y_t(\cdots \omega_{t-1}) S_{t-1}(\cdots \omega_{t-1})}{B_{t-1}} ,\] is self-financing, has value process $V_t$ as defined above, and replicates the contingent claim $X$. Moreover, for every $t$ and $\omega$, $V_t(\cdots \omega_t) = X_t(\cdots \omega_t)$.

Proof. First, it is clear from the definition of $x_t$ that for each $t$, the relation \[ V_t = x_{t+1} B_t + y_{t+1} S_t \] holds for every $\omega \in \Omega_T$.

Next, to see that the self-financing condition holds, we check that \[ V_{t+1} = x_{t+1} B_{t+1} + y_{t+1} S_{t+1} \] for $t = 0, \dots, T$.

We have \[\begin{align} x_{t+1} B_{t+1} + y_{t+1} S_{t+1} & = \frac{V_t - y_{t+1} S_{t}}{B_t} B_{t+1} + y_{t+1} S_{t+1} \\ & = (1+r) (V_t - y_{t+1}S_{t}) + y_{t+1} S_{t+1} \\ & = V_{t+1}, \end{align}\] by definition.

Now, to see that $V$ and $X$ always coincide, we use induction. The base case $V_0 = X_0$ is true by definition. Next, we fix $\omega_1\dotsm\omega_t$ and use $V_t(\omega_1\dotsm\omega_t) = X_t(\omega_1\dotsm\omega_t)$ to show that \[\begin{align*} V_{t+1}(\cdots\omega_t1) &= X_{t+1}(\cdots\omega_t1), \quad\text{and}\\ V_{t+1}(\cdots\omega_t0) &= X_{t+1}(\cdots\omega_t0). \end{align*}\]

First, if $\omega_{t+1} = 1$, we use the fact that $S_{t+1}(\cdots \omega_t 1) = u S_t(\cdots \omega_t)$ in the wealth equation to write \[\begin{align} V_{t+1}(\cdots\omega_t 1) &= y_{t+1} u S_t + (1+r) (V_t - y_{t+1}S_t) \\ & = y_{t+1} S_t \big(u - (1+r) \big) + (1+r) V_t. \end{align}\] (Here, we have stopped writing $\cdots \omega_t$ in the right hand side, to simplify the notation.)

Using the inductive hypothesis and the expression for $y_{t+1}$, we get \[\begin{align} V_{t+1}(\cdots\omega_t 1) &= \frac{X_{t+1}(1) - X_{t+1}(0)}{uS_t - dS_t}S_t \big(u - (1+r)\big) + (1+r)X_t\\ &=( X_{t+1}(1) - X_{t+1}(0) ) \frac{u - (1+r)}{u-d} + (1+r) X_t\\ &=( X_{t+1}(1) - X_{t+1}(0) ) q_d + [q_u X_{t+1}(1) + q_d X_{t+1}(0)]\\ &= X_{t+1}(1), \end{align}\] as required.

Exercise: Check that, when $\omega_{t+1} = 0$, we also have $V_{t+1} = X_{t+1}$.

5.2 Popular options

Some background on vocabulary

In many textbooks, options such as those in this section are described as “exotic”. I’ve chosen not to use that word in these lecture notes; you can find an explanation put together by our decolonisation interns, here.

A digital (or binary) option is a contract whose payoff depends in a discontinuous way on the terminal price of the underlying asset. We can describe the payoff functions succinctly using indicator functions: for an event $A$ we write $1_A$ for the random variable \[ 1_A(\omega) = \begin{cases} 1 &\text{if $\omega \in A$},\\ 0 &\text{otherwise}. \end{cases} \] In other words, $1_A$ takes the value 1 exactly when $A$ occurs, and 0 otherwise. For example, \[ 1_{\{S_T >K\}} = \begin{cases} 1 &\text{if $S_T > K$},\\ 0 &\text{otherwise}. \end{cases} \]

The payoff of the cash-or-nothing binary option is given by \[ \begin{split} X&=\eta 1_{\{S_T>K\}} \quad\text{for a call option, }\\ X&=\eta 1_{\{S_T<K\}} \quad\text{for a put option}, \end{split} \] where $\eta$ is a pre-specified amount; and the payoff of the asset-or-nothing binary option is given by \[ \begin{split} X&=S_T 1_{\{S_T>K\}} \quad\text{(call)},\\ X&=S_T 1_{\{S_T<K\}} \quad\text{(put)}. \end{split} \]

Gap options are contingent claims whose payoffs are given by \[ \begin{split} X&=(S_T-\eta)1_{\{S_T>K\}} \quad\text{(call)},\\ X&=(\eta-S_T)1_{\{S_T<K\}}\quad\text{(put)}. \end{split} \] Here again $\eta$ is a pre-specified amount.

Lookback options are contingent claims whose payoff depends not only on the terminal price of the underlying asset but also on asset price fluctuations during the option’s life time. There are two standard lookback options. The payoff of the standard lookback call option is given by \[ LC_T = S_T - S_{\rm min}, \] where $S_{\rm min}=\min_{t\in [0, T]}S_t$ is the minimum value of the stock price during its lifetime. The payoff of the standard lookback put option is given by \[ LP_T = S_{\rm max} - S_T, \] where $S_{\rm max}=\max_{t\in [0, T]}S_t$ is the maximum value of the stock price.

Let $S_0=4, u =2, d=\frac{1}{2}, r=\frac{1}{4}$. We find the prices of the lookback option \[ X_3=\max\{S_0, S_1, S_2, S_3\}-S_3 \] at times $t=0, 1, 2$.

First we find $q_u = {\displaystyle\frac{\frac54-\frac12}{2-\frac12}} = \frac12$ and $q_d = {\displaystyle\frac{2-\frac54}{2-\frac12}} = \frac12$. Writing $S_{\rm max} = \max\{S_0,S_1,S_2,S_3\}$, we find the following values for $S_{\rm max}, S_3$ and $X_3$ as functions of $\omega \in \Omega_3$: \[ \begin{matrix} \begin{array}{|c||c|c|c|c|c|c|c|c|} \hline\omega_1\omega_2\omega_3 & 111 & 110 & 101 & 100 & 011 & 010 & 001 & 000 \\ \hline S_{\rm max}(\omega_1\omega_2\omega_3) & 32 & 16 & 8 & 8 & 8 & 4 & 4 & 4 \\[2pt] S_3(\omega_1\omega_2\omega_3) & 32 & 8 & 8 & 2 & 8 & 2 & 2 & \frac12 \\[2pt] \hline &&&&&&&&\\[-10pt] X_3(\omega_1\omega_2\omega_3) & 0 & 8 & 0 & 6 & 0 & 2 & 2 & \frac72 \\[2pt] \hline \end{array} \end{matrix} \]

Then we use the recursive definitions for $X_2, X_1, X_0$ to find the prices at time $t=2,1,0$: \[ \begin{split} X_2(11) &= \frac{1}{1+r}[q_u X_3(111) + q_d X_3(110)]\\ &\textstyle = \frac45 \times [{\textstyle\frac12 X_3(111) + \frac12 X_3(110)} ] = \frac{16}{5},\\ X_2(10) &= \textstyle \frac45 \times[\frac12 X_3(101) + \frac12 X_3(100)] = \frac{12}{5},\\ X_2(01) &= \textstyle \frac45 \times[\frac12 X_3(011) + \frac12 X_3(010)] = \frac{4}{5},\\ X_2(00) &= \textstyle \frac45 \times[\frac12 X_3(001) + \frac12 X_3(000)] = \frac{11}{5}, \end{split} \] and \[ \begin{split} X_1(1) &= \textstyle \frac45\times[{\textstyle\frac12 X_2(11) + \frac12 X_2(10)}] = \frac{56}{25},\\ X_1(0) &= \textstyle \frac45\times[\frac12 X_2(01) + \frac12 X_2(00)] = \frac{6}{5}, \end{split} \] and finally $X_0 = \frac45\times[\frac12 X_1(1) + \frac12 X_1(0)] = \frac{172}{125}$.

Barrier Call Options: Let $L, K>0$ be two given parameters, and $T>0$ a given maturity. There are four types of barrier call options on the underlying asset with strike price $K$, barrier $L$ and maturity $T$:

When $L>S_0$:
- an up and out call option is defined by the payoff at the maturity $T$: \[ UOC_T=(S_T-K)^+1_{\{S_{\rm max} \le L\}}. \] The payoff is that of a European call option if the price process of the underlying asset never reaches the barrier $L$ before maturity. Otherwise it is zero (the contract knocks out).
- an up and in call option is defined by the payoff at the maturity $T$: \[ UIC_T=(S_T-K)^+1_{\{ S_{\rm max} > L\}} \] The payoff is that of a European call option if the price process of the underlying asset crosses the barrier $L$ before maturity. Otherwise it is zero (the contract knocks out). We have \[ UOC_T+UIC_T=C_T, \] where $C_T$ is the payoff of the corresponding European call option.
When $L<S_0$:
- an down and out call option is defined by the payoff at the maturity $T$: \[ DOC_T=(S_T-K)^+1_{\{ S_{\rm min} > L\}}. \] The payoff is that of a European call option if the price process of the underlying asset never reaches the barrier $L$ before maturity. Otherwise it is zero (the contract knocks out).
- an down and in call option is defined by the payoff at the maturity $T$: \[ DIC_T=(S_T-K)^+1_{\{S_{\rm min} \le L\}} \] The payoff is that of a European call option if the price process of the underlying asset crosses the barrier $L$ before maturity. Otherwise it is zero (the contract knocks out). Clearly, \[ DOC_T+DIC_T=C_T, \] where $C_T$ is the payoff of the corresponding European call option.

Barrier put options: Replace calls by puts in the previous definitions.

An Asian option is a generic name for the class of options whose terminal payoff is based on average asset values during some period within the options lifetime. Let $T$ be the exercise date and $T_0$ be the beginning date of the averaging period, for some $0\le T_0\le T$. Then the payoff at expiry of an Asian call option is given by \[ C_T^A\equiv (A_S(T_0, T)-K)^+, \] where $A_S(T_0, T)$ can be the continuous arithmetic average \[ A_S(T_0, T)=\frac{1}{T-T_0}\int_{T_0}^TS_tdt, \] or a discrete average \[ A_S(T_0, T)=\frac{1}{n}\sum_{i=0}^{n-1}S_{T_i}, \] where $n$ is a positive integer and $T_0<T_1<T_2<\cdots<T_n\le T$, or sometimes a geometric average \[ A_S(T_0, T)=\bigg(\prod_{i=0}^{n-1}S_{T_i}\bigg)^{1/n}, \] again for some $T_0<T_1<T_2<\cdots<T_n\le T$. An Asian put option can be defined similarly.

5.3 American Options

An American call or put option gives the right to buy or, respectively, to sell the underlying asset for the strike price $K$ at any time between now and a specified future time $T$, called the expiry time. In other words, an American option can be exercised at any time up to and including expiry. The holder of an American type contingent claim with contract function $\Phi(x)$ will receive a payoff $\Phi(S_{\tau})$ at time $\tau$, where $\tau$ is a random variable chosen by the holder. The random variable $\tau$ must take values in $\{0,1,\dots,T\}$ and specifies the choice of the exercise time for the holder. This means that if the option will be exercised at time $\tau=t$ then the payoff will be $\Phi(S_t)$ at time $t$. Of course, it can be exercised only once. The holder does not have complete freedom to choose $\tau$ arbitrarily; it must be a stopping time, i.e., the decision to exercise the option at time $t$ can only depend on what has happened upto time $t$ and not on the future randomness. Some examples of stopping times are $\tau \equiv T$ (always exercise at time $T$), and $\tau = \inf\{t : S_t \geq L\} \wedge T$ (exercise at the first time that the share price is at least price $L$, or at time $T$ if that never happens).

It it possible to show that the price of the American option at time 0 equals $\sup_{\tau} \{ \mathbb{E}_{\mathbb{Q}}[ (1+r)^{-\tau} \Phi(S_\tau)] \}$, where the supremum is taken over all stopping times $\tau$. We give a rough argument, as follows. Suppose the holder exercises the American option according to the stopping time $\tau$, so that the payoff to the holder is the amount $\Phi(S_\tau)$ at time $\tau$. This is equivalent to a present value of $(1+r)^{-\tau} \Phi(S_\tau)$, so risk-neutral valuation tells us that the value at time 0 would be $\mathbb{E}_{\mathbb{Q}}[ (1+r)^{-\tau} \Phi(S_\tau)]$. But since the holder is free to choose any stopping time $\tau$, they will choose the $\tau$ that maximises this value at time 0, hence the value must be $\sup_{\tau} \{ \mathbb{E}_{\mathbb{Q}}[ (1+r)^{-\tau} \Phi(S_\tau)] \}$.

The following pricing algorithm allows us to compute the value of the American option at any time $t = 0,1,\dots,T$. Let $V^A_t$ denote the price of the American option at time $t$ (that has not been exercised yet). Using the risk-neutral valuation formula, we can price an American option inductively, as follows:

At $t= T$: $V^A_T = \Phi(S_T)$, because if we hold an American option at time $t = T$, the only choice is to exercise or not at the expiry time $T$, so it has the same value as the European version of the option.

At $t< T$: suppose we know the value of the American option at time $t+1$ is $V^A_{t+1}$, then $V^A_t = \max \big\{\, \Phi(S_t)\, ,\, \frac{1}{1+r} \mathbb{E}_{\mathbb{Q}}[V^A_{t+1} \mid \F_t]\, \big\}$.

Why do we take a “max” here? It’s because if we hold an American option at time $t$, we have the choice to either exercise early at time $t$, or wait. The value of exercising early is $\Phi(S_t)$, the contract function $\Phi$ evaluated at the current share price $S_t$; the value of waiting at time $t$ is the risk-neutral price $\frac{1}{1+r} \mathbb{E}_{\mathbb{Q}}[V^A_{t+1}\mid \F_t]$, and we will choose whichever gives us more.

Summarising, we have the following pricing algorithm for American options: \[ V^A_t(\omega_1\dotsm\omega_t) = \begin{cases} \Phi(S_T(\omega_1\dotsm\omega_T)) & \text{if $t=T$},\\ \max\big\{ \Phi(S_t(\omega_1\dotsm\omega_t)) , \frac{1}{1+r}[q_u V^A_{t+1}(\omega_1\dotsm\omega_t1) + q_d V^A_{t+1}(\omega_1\dotsm\omega_t0)] \big\} & \text{if $t< T$}. \end{cases} \]

To see the algorithm in more detail, let’s consider an American option expiring after $2$ steps with the contract function $\Phi(x)$. The value of this option at time $2$ (if it is not exercised before time $2$) is clearly $\Phi(S_2(\omega_1\omega_2))$. At time $1$ the option holder will have the choice to exercise immediately, with payoff $\Phi(S_1(\omega_1))$, or to wait until time $2$, when the value of the option will become $\Phi(S_2(\omega_1\omega_2))$. The value of waiting at time $1$ is therefore given by \[ \frac{1}{1+r}[q_{u }\Phi(S_2(\omega_11))+q_d\Phi(S_2(\omega_10))]. \] In effect, the option holder has the choice between the “value of waiting” and the immediate payoff $\Phi(S_1(\omega_1))$. The American option at time $1$ will, therefore, be worth the higher of these two: \[ V^A_1(\omega_1) = \max\{\Phi(S_1(\omega_1)), \frac{1}{1+r}[q_{u }\Phi(S_2(\omega_1H))+q_d\Phi(S_2(\omega_1T))]\}. \]
The same reasoning applied at time 0 gives \[ V^A_0 = \max\{ \Phi(S_0), \frac{1}{1+r}[q_uV^A_1(H) + q_dV^A_1(T)]\}. \]

Consider an American put option with strike price $K=80$ pounds expiring at time $2$ on a stock with initial price $S_0=80$ pounds in a Binomial model with $u =1.1, d=0.95$ and $r=0.05$. The stock values are: \[ \begin{matrix} \begin{array}{l|lllll} t&0&&1&&2\\ \hline &&&&&96.80\\ &&&88.00&<&\\ S_t&80.00&<&&&83.60\\ &&&76.00&<&\\ &&&&&72.20\\ \end{array} \end{matrix} \] The price of the American put will be denoted by $P^A_t$ for $t=0, 1, 2$ and its price at time $2$ is $(80-S_2)^+$ given in the following tree: \[ \begin{matrix} \begin{array}{l|lllll} t&0&&1&&2\\ \hline &&&&&0.00\\ &&&?&<&\\ P^A_t&?&<&&&0.00\\ &&&?&<&\\ &&&&&7.80\\ \end{array} \end{matrix} \] First observe that $q_{u }=\frac{1+r-d}{u -d}=\frac{2}{3}$ and $q_d=\frac{1}{3}$. At time $1$ the option holder can choose between exercising the option immediately or waiting until time $2$. In the up state at time $1$ the immediate payoff is $(K-S_1)^+=(80-88)^+=0$ and the value of waiting is $\frac{1}{1+r}[q_{u }\times 0+q_d\times 0]=0$. In the down state the immediate payoff is $4$ pounds, while the value of waiting is $1.05^{-1}\times \frac{1}{3}\times 7.8 \approx 2.48.$ The option holder will choose the higher value (i.e., to exercise the option in the down state at time $1$). This gives the time $1$ value of the American put \[ \begin{matrix} \begin{array}{l|lllll} t&0&&1&&2\\ \hline &&&&&0.00\\ &&&0.00&<&\\ P^A_t&?&<&&&0.00\\ &&&4.00&<&\\ &&&&&7.80\\ \end{array} \end{matrix} \] At time $0$ the choice is, once again, between the payoff $(80-S_0)^+$, which is zero, or the value of waiting, which is $1.05^{-1}\times \frac{1}{3}\times 4 \approx 1.27$ pounds. Taking the higher of the two completes the tree of the option prices: \[ \begin{matrix} \begin{array}{l|lllll} t&0&&1&&2\\ \hline &&&&&0.00\\ &&&0.00&<&\\ P^A_t&1.27&<&&&0.00\\ &&&4.00&<&\\ &&&&&7.80\\ \end{array} \end{matrix} \]
Therefore the price of the American put is $P^A_0=1.27$ pounds.

In comparison, the price of a European put is $P_0^E=1.05^{-1}\times \frac{1}{3}\times 2.48 \approx 0.79.$ Here we use $2.48$ (not $4$) in the calculation as European option is exercised at time $2$.

What is the price of an American call in the above example? Although in general an American option is at least as valuable as the equivalent European option (because of the additional choice in when to exercise the option), for call options (on a stock that does not pay dividends) the American and European options have the same price.

Theorem 5.2 The prices of American and European call options on a stock that pays no dividends are equal $C^A=C^E$, whenever the strike price $K$ and expiry time $T$ are the same for both options.

Proof. The relation $C^A\geq C^E$ is clear as the American call option gives higher payoff (since you can exercise your right at any time) than the European call. (It’s also possible to give an arbitrage argument to prove this.) Now if $C^A>C^E$, then

write and sell an American call.
buy a European call.
invest the difference $C^A-C^E$ risk free with interest rate $r$.

If the American call is exercised at time $t\le T$, then borrow a share and sell it for $K$ to settle your obligation as a writer of the call option, investing $K$ at the rate $r$. Then at time $T$ you can use the European call to buy a share for $K$ and close your short position in stock. Your arbitrage profit will be \[ (C^A-C^E)(1+r)^T+K(1+r)^{T-t}-K>0. \] If the American option is not exercised at all, you will end up with the European option and an arbitrage profit $(C^A-C^E)(1+r)^T$. This proves that $C^A=C^E$.