Chapter 4 Flashcards
1
Q
What are the steps for binomial option pricing
A
- Draw the diagram for the share prices at time 0 and time 1 (up and down)
- Draw one for Call option: ST-K =CT
- Get the hedge ratio by doing (h x ST)-CT and equate both in the specific times.
- Equate the current (h x S0) - C0 with upper bound (hxS0)-C0 x discount rate(exp-(risk free rate x t).
- If there is one step then t=1/12 as per month, if two steps then both have to be a total of a month so each is two weeks. so each t=1/24.
- If two steps then the value we have obtained is the C0 and the one below is zero as we wont need to exercise if K>ST
2
Q
What is the formula for risk neutral binomial pricing
A
C0 = [πu × Pay-off upper + (1 − πu) × payoff lower] × e(−rf×t)
3
Q
What is the formula for put call parity
A
S + P = PV(k) + C
4
Q
What is the formula for Black scholes
A
C = P(X=x1)S − Ke(rf ×t)P(X=x2) where
x1 =(1/σ√t)(ln S/K+(rf +σ^2/2)t)
x2 = x1 − σ√t