Chapter 13 - The Binomial Model

Question 1

Binomial model assumptions

Answer 1

1. Assets may be bought and sold at integer times t= 0,1,2,3,…
2. Assets may be held in any amount
3. There are no taxes or transaction costs
4. There are no arbitrage opportunities <=> d < e^r < u

Question 2

Replicating portfolio

Answer 2

A replicating portfolio will always precisely reproduce the relevant payoff or cashflow.
A replicating portfolio is only a hedging portfolio if the position taken in it is opposite to that of the payoff or cashfloe which it aims to reproduce.

Question 3

Hedging portfolio

Answer 3

A hedging portfolio aims to reduce the amount of risk relating to a derivative strategy, but is not guaranteed to reproduce the payoff or cashflow precisely.

Question 4

Equivalent measures

Answer 4

Two measures P and Q which apply to the same sigma-algebra F are said to be equivalent if for any event E in F:
P(E)>0 iff Q(E)>0
Where P(E) and Q(E) are the probabilities of E under P and Q respectively.

Question 5

Other names for state price deflator

Answer 5

1. Deflator
2. State price density
3. Pricing kernel
4. Stochastic discount factor