FBE559.slides.07

25 0 risk neutral pricing works for the stock itself

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: people act as if we don’t need compensation to bear risk Binomial Stock Example I: Another Alternate Solution We want to price the call option: Stock: 100 150 50 Bond: 95 100 100 C0 =??? 25 0 Risk-neutral pricing works for the stock itself, so for some q : 0.95(q 150 + (1 − q )50) = 100 In words: the discounted expected payoff of the stock using the risk-neutral probabilities and the risk-free rate is the price of the stock. Binomial Stock Example I: Another Alternate Solution When we solve, we get 95q + 45 = 100, or q= 55 . 95 So the call price is: C0 = 0.95 Jump to Method #1 55 55 × 25 + (1 − ) × 0 95 95 Jump to Method #2 = 13.75 Binomial Stock Example I: Another Alternate Solution Also notice using this we can price any other option we want. A put struck at 90 will cost: P0 = 0.95 55 55 × 0 + (1 − ) × 40 95 95 = 16 Thus once we have q we don’t have to start over with two equations/two unknowns or computing the ∆ Ways to compute Binomial Option Price Now we have three ways to compute the price: 1 Find replicating portf...
View Full Document

This document was uploaded on 10/28/2013.

Ask a homework question - tutors are online