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Postby ameyakukde » Sun Apr 07, 2013 12:34 am

Suppose strike price of the call option is Rs. 90 and current price is 90. A one-step binomial model is built to price the option. Suppose the price of the stock moves up to 94.5 with probability 0.6 and moves down to 85.71 with probability 0.4. Calculate the price of the option is each step corresponds to 0.01 years and risk-free rate of interest is 5%.

How do we know that the probabilities given here are the risk neutral probabilities?

I mean there could be a possibility that they are the prob of stock price moving up or down not necessarily the risk neutral prob of stock price going up or down.

What am I missing?

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Postby lokesh1 » Wed Apr 10, 2013 10:45 am

Hey Ameya

The probabilities for stock movement either upwards or downwards given in the question is assumed to be be risk neutral probabilities unless specifically mentioned. It is also assumed here that the investors are risk neutral.

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