Unformatted text preview: state one because is the stock price is lower than the strike price there is no need to exercise that option. In state 2 we show that the D(t)= 2 because if the strike price is 38, and the stock goes to 40 we make $2 profit. Now if we set a separate vector L as follows: [1] = [1+.052632 1+.052632] [L1] [36.2] [36 40] [L2] [C(t)] [2 0] [D(t)] [0 2] As shown in “An Introduction to the Mathematics of Financial Derivatives” by Neftci, if we can solve for vector L as positive probabilities, which we can in this problem because the matrices are solvable then there is no arbitrage possibilities in the system. [page 19] p1 = .44996 , p2= .500003 II P1=p1(1+.052632), P2=p2(1+.052632), so the risk adjusted probabilities P1 and P2 are .473642 and .526348...
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 Summer '10
 prasad
 Strike price

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