Binomial call with moves to 90 or 110
Question
With zero interest rates, a stock now at will be worth either (real-world probability ) or after one period. What is a call struck at worth?
Short answer
, whatever is. The risk-neutral probability of the up move satisfies , so , and the call pays in the up state: . Equivalently, half a share minus in cash replicates it. The real probability never enters.
Adapted from Joshi, Denson & Downes, Quant Job Interview Questions and Answers, Q2.50, p.21; question and answer rewritten by SelfMadeQuant.com.
See the hint and the full worked solution in the question bank (free account).
Open the worked solutionLessons behind this question
- The Binomial Model
- The One-Period Binomial Model: Replication, Delta Hedging, and Risk-Neutral Pricing
- Sample Spaces, Events, and the Probability Axioms
Start with a free lesson: Probability Fundamentals is part of a free topic. Create a free account, no card needed, to read it in full with worked solutions.
Read it free