FIN4520-Chapter18

FIN4520-Chapter18 - t (Figure 18.1, page 392 ) Su Sd S p 1...

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Binomial Trees in Practice Chapter 18 1
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Binomial Trees Binomial trees are frequently used to approximate the movements in the price of a stock or other asset. In each small interval of time the stock price is assumed to move up by a proportional amount u or to move down by a proportional amount d. This means that stock prices will follow a random walk - successive changes in value are independent. Suppose that the rate of return on the stock each period can have 2 possible values: u - 1 > 0 with probability p d - 1 < 0 with probability 1-p 2
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Movements in Time
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Unformatted text preview: t (Figure 18.1, page 392 ) Su Sd S p 1 3 4 Risk-Neutral Valuation To determine the value of the option, we construct a riskless hedged portfolio. We choose the tree parameters (p, u, and d) so that the tree gives the correct values for the mean and standard deviation of the stock price changes in a risk-neutral world. In a risk-neutral world, everyone is indifferent to risk so that all assets earn the risk-free rate. We value the option based on the idea that the expected return should be the risk-free interest rate. 5...
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This note was uploaded on 01/19/2012 for the course FIN 4520 taught by Professor Lucyackert during the Spring '12 term at Kennesaw.

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FIN4520-Chapter18 - t (Figure 18.1, page 392 ) Su Sd S p 1...

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