FBE559.slides.07

A mechanical answer arbitrage does not depend on

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Unformatted text preview: gh! Discussion of Binomial Pricing Question 1: Why does option price not depend on the probabilities? A mechanical answer: arbitrage does not depend on probability A deeper answer: information about probability already contained in today’s stock price Question 2: Does this mean that news about the stock price movement will not affect the price of the call option? It will. In fact, it will affect both. Question 3: Why can we replicate the call option in this case? Binomial assumption is the key Summary So Far We have seen how to price option in the two-period binomial setting. We saw two ways to do it: 1 Find replicating portfolio with two equations and two unknowns 2 Find the stock ∆ to hedge the option position This is pretty cool: we now know how to do some complicated pricing we didn’t know how to do before. What is next? More things we can do with this model: 1 Multi-period setting 2 Another way to compute the prices: risk-neutral pricing Risk-neutral pricing will be pretty really cool because we will be able to think more about the economics behind the prices....
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