Lesson 6 of 6 · All lessons in this module
  1. Why options need a price model: the one-period binomial setup
  2. The hedge ratio and the riskless portfolioVideo lesson
  3. From the riskless hedge to the option price
  4. Risk neutrality and risk-neutral probabilitiesVideo lesson
  5. What does and does not move a binomial option value
  6. Integrated cases: an underpriced put and a tree with a negative rate

Lesson 6 of 6 · 14 min

Integrated cases: an underpriced put and a tree with a negative rate

A binomial case hands you a data panel and chains the questions: read the tree, find the hedge ratio and π, price the option, then test the quote against the model or price it with a risk-free rate that may be negative.

In short

  • Read the panel in order: the two end prices, the option's payoff in each state, the rate for the period (not the annual rate), then the quoted price.
  • Get h* from the payoffs alone. For a put it is negative, so the put and the shares are bought (or sold) together.
  • Value with π=(1+r−Rd)/(Ru−Rd)\pi = (1+r-R^d)/(R^u-R^d) and discount at 1+r1+r; cross-check by replication or put-call parity.
  • An underpriced option is bought with its hedge. The hedge's riskless return is end value ÷ total outlay − 1, and it is compared with r, not with zero.
  • A negative rate does not change a formula: 1+r1+r is simply below 1, so π is lower and discounting adds value.

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