Lecture14 - value options with binomial model

# Sincewedontneedtheprobabilitiesofthetwo

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Unformatted text preview: ies. Because the option value depends on the stock price, it also incorporates these probabilities. Since we don’t need the probabilities of the two states to value the call, we can select any probabilities we want and still come up with the right answer 4 Solving by Risk-Neutral Probabilities The trick is to assume that investors are risk­neutral, so they only care about the expected return and not about risk. Thus, they will use the risk­free rate of return to discount all cash flows. Because we assume investors are risk­neutral we come up with risk­neutral probabilities. 5 Solving by Risk-Neutral Probabilities To calculate these probabilities, discount the cash flows of a risky asset (whose price you know) at the risk­free rate and find the probabilities that give the known price. You know the current price S, the possible future prices SH and SL, and the risk­free rate rf. Thus, π solves: S = [π × SH + (1 ­ π) ×...
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