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lecture06 - Shostakovich The binomial model Lecture 6 -...

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Unformatted text preview: Shostakovich The binomial model Lecture 6 - Binomial trees BUSI 588, Fall 2011 Diego Garc a Kenan-Flagler Business School UNC at Chapel Hill September 14th, 2011 c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 6 - Binomial trees 1 / 20 Shostakovich The binomial model Outline and handouts 1 Shostakovich Valuation Replication 2 The binomial model The magic Assumptions and calibration Handouts today: Class slides and case 6 solutions (Shostakovich). Homework 2 solutions. Announcements: We are done with concepts at some point next week - then mostly applications. c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 6 - Binomial trees 2 / 20 Shostakovich The binomial model Homework 2 highlights Problems 1 and 2: busy work, make sure everyone knows how to price forwards and calls in a one period binomial. Problem 3: forward pricing meets reality. Costs of storage, convenience yields. The theory just cannot fit natural gas - it is not possible to store it. Problem 4: can do Bachelier with your eyes closed. Problem 5: being more precise with expected returns on derivatives relative to the underlying asset. Problem 6: super-replication. Portfolio that dominates cash flows of derivative provides upper bound. Portfolio that is dominated by cash flows of derivative provides lower bound. c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 6 - Binomial trees 3 / 20 Shostakovich The binomial model Last class Soul-searching: In a binomial world we can price assets using the formula V X = p u X u + p d X d 1 + r f ; take expected value (using risk-neutral probabilities) and discount at the risk-free rate. The risk-neutral probabilities did not have much to do with probabilities: they were (normalized) prices of pure securities. Risk-neutral pricing is isomorphic to pricing by arbitrage. In the background: replicating portfolio . Today we take this argument to more than one-period. c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 6 - Binomial trees 4 / 20 Shostakovich The binomial model Shostakovich Stock follows binomial tree. Risk-free asset yielding 1% (per period)....
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This note was uploaded on 11/25/2011 for the course BUSI 588 taught by Professor Staff during the Fall '10 term at UNC.

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lecture06 - Shostakovich The binomial model Lecture 6 -...

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