Chapter 4 Flashcards

1
Q

What are the steps for binomial option pricing

A
  1. Draw the diagram for the share prices at time 0 and time 1 (up and down)
  2. Draw one for Call option: ST-K =CT
  3. Get the hedge ratio by doing (h x ST)-CT and equate both in the specific times.
  4. Equate the current (h x S0) - C0 with upper bound (hxS0)-C0 x discount rate(exp-(risk free rate x t).
  5. 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.
  6. 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
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2
Q

What is the formula for risk neutral binomial pricing

A

C0 = [πu × Pay-off upper + (1 − πu) × payoff lower] × e(−rf×t)

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3
Q

What is the formula for put call parity

A

S + P = PV(k) + C

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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

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