One can alternatively think of the calculation as the

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Unformatted text preview: r negative, they behave like probabilities. One can alternatively think of the calculation as “The expected payoff under the stateprice probabilities,” and use the notation to find the following basic pricing formula: (10.1) 10.2 Pricing Derivatives This framework is perfect for pricing derivatives, since the values of the underlying securities defines the relevant states. Example Stock MNO has price today ( ) of $98, and will next period either have a price of or a price of . These two mutually exclusive cases defines all relevant future states for pricing a derivative security written on MNO stock. ✟ ✟✟ ✟✟ ❍ ❍❍ ✯ ✟ ✟✟ ❍ ❍❍ ❍ ❥ ❍ Pricing derivatives merely consist of finding the future cash flows from the derivative as a function of the value of the underlying, and applying the same state price probabilities in the basic pricing relation (10.1). The state price probabilities have to be the same for all derivatives. This follows from the no arbitrage assumption and will be discussed further in chapter 14. 10.2 Pricing Derivatives 91 Example What is the price of an...
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