CFA Mock AM Derivatives

When calculating the value of the option, we need the probabiliy of the up-move and of the down-move. I doubted when I was writing the exam because they said

“Using the Black–Scholes–Merton model, I calculate that the normal probabilities for the Riga Index are 59% for a gain each year and 41% for a loss.”

The right answer is to calculate the probability with the formula (1+R-D)/U-D, but they did not explain why. Is it because we need risk-neutral probabilities?

The fact that they said “normal probabilities” sounded weird to me and for that reason I chose the formula which seemed to be correct…


Yes: you want risk-neutral probabilities. (Thought they’re better described as risk-neutral _ weights _, not probabilities.)

Thanks Sir.

My pleasure.