Option prices when research favours one asset
Question
Two assets currently have identical binomial trees for their future prices, but your research team believes one of them is a much better investment. How do the prices of options on the two compare?
Short answer
They are identical. Option prices come from replication on the tree, which uses only the possible future prices and the interest rate; the real-world probabilities, and so any view about expected returns, do not enter.
Adapted from Joshi, Denson & Downes, Quant Job Interview Questions and Answers, Q2.54, p.21; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- The Binomial Model
- Option Mechanics: Calls, Puts, Moneyness, Intrinsic Value, and Exchange vs. OTC Markets
- Option Trading Strategies: Spreads, Combinations, and Payoff Engineering
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