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Binomial call with moves to 90 or 110

Question

With zero interest rates, a stock now at 100100 will be worth either 110110 (real-world probability pp) or 9090 after one period. What is a call struck at 100100 worth?

Short answer

55, whatever pp is. The risk-neutral probability of the up move satisfies 110q+90(1−q)=100110q+90(1-q)=100, so q=12q=\tfrac12, and the call pays 1010 in the up state: 12×10=5\tfrac12\times10=5. Equivalently, half a share minus 4545 in cash replicates it. The real probability pp never enters.

Adapted from Joshi, Denson & Downes, Quant Job Interview Questions and Answers, Q2.50, p.21; question and answer rewritten by SelfMadeQuant.com.

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