7.10 Valuing a derivative using a one-period binomial model

Question 1

The binomial model

Answer 1

To value an option, we must make assumptions about the future price of its underlying asset.

The binomial model provides an attractive framework for option valuation because it only requires us to assume that, over any given interval, the price of the underlying, S0, will increase by a factor of u to Su1 or decrease by a factor of d to Sd1.

Question 2

Which of the following is most likely to be correct with respect to the binomial valuation of options?

A
The difference between the up and down factors reflects the volatility of the underlying

B
The risk-neutral formula of a call option uses the actual probability that the underlying will decrease in price

C
The implied option price is determined by the expected payoffs using risk-neutral probabilities and discounting at the risk-free rate plus a market risk premium

Answer 2

A
The difference between the up and down factors reflects the volatility of the underlying

Question 3

With respect to forward contract pricing and valuation, which of the following is least accurate? The forward price is:

A
unaffected by an investor’s degree of risk aversion.

B
equal to the spot price discounted at the risk-free rate over the life of the contract minus the future value of benefits and costs.

C
fixed at the start of the contract, and the value of the forward contract starts at zero and then changes over the life of the contract.

Answer 3

B
equal to the spot price discounted at the risk-free rate over the life of the contract minus the future value of benefits and costs.