This is post #2 on the binomial option pricing model. In part 1, we derive the oneperiod binomial option pricing formulas. The purpose of post #2:

Post #2: Discuss the underlying issues in the oneperiod model – e.g. arbitrage in the binomial tree and riskneutral pricing.
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The oneperiod binomial option pricing formulas
For easier reference, we list out the option pricing formulas derived in part 1. The binomial tree models the stock price at expiration of the option.
The following is a tree showing the value of the option at expiration.
Replicating Portfolio
Price of the Option
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Arbitrage in the binomial tree
In formulas (1), (2) and (4), it seems that we choose the up factor and the down factor arbitrarily. It turns out that the assumed stock price factors and should be set in such a way that arbitrage opportunities are not possible. The factors and must follow the following relationship.
Multiplying (5) by the initial stock price yields the following:
The middle term in (6) is the forward price on the stock. The relationship (6) indicates that whatever the values of the up factor and the down factor are, the end of period upped stock price must be larger than the forward price and the downed stock price must be below the forward price. Violation of this requirement will yield arbitrage opportunities.
To see that arbitrage opportunities will arise if (5) is violated, suppose that . Multiply by the initial stock price produces . Since , we have the following:
Based on the above inequality (a), the arbitrage opportunity: short shares of stock (borrow that many shares and sell) and lend (the short sales proceeds). At time , you need to buy back 1 share at price . The value of the bond is . What occurs at time is that you pay to buy back 1 share and receive . Based on (a), both and , which mean riskfree profit. So it must be the case that .
Suppose that . This also leads to arbitrage opportunities. Multiplying by the initial stock price produces the following:
The arbitrage opportunity: borrow at the riskfree rate and use the borrowed fund to buy shares of stock. The relationship (b) says that regardless of the stock price at time (up or down), the stock price is always greater than the amount that has to be repaid. Thus there are riskfree profits in either case: and .
Thus relationship (5) must hold for the stock price movement factors and . In fact, one way to set the factors and is to increase or decrease a volatility adjustment to the riskfree return factor . The resulting and are:
For more information about (7), see part 1.
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Riskneutral pricing
At first glance, the pricing of an option on stock ought to require the use of a probability model. The price of the option depends on the price of the stock at expiration of the European option. The stock price at the end of the option period is uncertain. Thus to price the option, we need to find a way to characterize the uncertainty of the stock prices at expiration. Since the future stock prices are random, it is natural to think that we need a probability model to describe the uncertain stock prices. The above derivation of the binomial option pricing model shows that probabilities of the future stock prices are not necessary. All we use is the binomial assumption of stock prices. The trick is then to determine a replicating portfolio of holding shares and lending a dollar amount . Because the replicating portfolio has the same payoff as the option, the movement of the stock prices (the up and the down prices) is irrelevant to the calculation of the price of the option.
However, there is a probabilistic interpretation of the option price in (4). Note that the terms and in formula (4) sum to 1.0. The two terms are also positive because of relationship (5). So they can be interpret as probabilities. So we have:
Then pricing formula (4) becomes:
The formula is called the riskneutral probability. From a calculation standpoint, the riskneutral probability is another way to calculate the price of an option in the oneperiod binomial model. Simply calculate the riskneutral probabilities. Then use them to weight the option values and (and also discount to time 0).
If and are interpreted as probabilities, then the pricing formula (5) says that the price of an option is the expected value of the end of period options values discounted at the riskfree rate. On the other hand, let’s use and to compute the expected value of the stock prices.
The last term in the above derivation is , which is the forward price on a stock that pays continuous dividends (derived in this previous post). Thus if we use and to calculated the expected value of the stock prices, we get the forward price. This is why and are called riskneutral probabilities since they are the probabilities for which the expected value of the stock prices is the forward price. In particular, is the riskneutral probability of an increase in the stock price.
We conclude this post with an example on using riskneutral probabilities to compute option prices. This example is Example 3 in part 1.
Example 1
Suppose that the future prices for a stock are modeled with a oneperiod binomial tree with volatility 30% and having a period of 6 months. The current price of the stock is $60. The stock pays no dividends. The annual riskfree interest rate is 4%. Use riskneutral probabilities to price the following options.
 A European 60strike call option on this stock that will expire in 6 months.
 A European 60strike put option on this stock that will expire in 6 months.
First calculate the and , and the stock prices at expiration:
1.261286251
0.825197907
60 (1.261286251) = $75.67717506
60 (0.825197907) = $49.51187441
Now the riskneutral probabilities:

0.447164974
0.552835026
Then the option prices are:

$6.871470666 (call)
$5.683391065 (put)
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Practice Problems
Practice problems can be found in in this blog post in a companion blog.
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