Derivatives - LOS 50.b

Reads “Calculate and interpret prices of interest rate options and options on assets using one- and two-period binomial models.”

In demonstrating the concept of a one-period binomial, Schweser goes into an example wherein they calc the profit of an arbitrage opportunity.

Presumably though we don’t have to know how to calc arbitrage profits in this context, right?

Also related, are we responsible for knowing how to calc the probabilities of the up and down moves using the “risk neutral probability” formula (1+Rf-D) / (U-D)?

Schweser is unclear on this, it says “the distinction b/w actual and risk neutral probs is not part of the L2 curriculum.” But then you clearly have to use it in the blue box example and in a challenge problem.

Yes we are responsible for knowing that. Infact without knowing the risk netural probablilyt, youll not be able to calculate the option cost.

Thanks - but is that a no on the arbitrage?

course we do… arbitrage is possible if the price differs from the calculated value. simply buy the cheaper one and sell the more expensive.

Yes I get how a basic arb works, but see p. 64 in schweser.

Question is if that particular arb calc is fair game - they use the delta hedge to make a portfolio, calc payoffs, and calc arb profit. I think they are just using it to demonstrate the concept of a delta hedge.

Even in the later options material directly on delta hedging, they don’t talk about the arbitrage at all, and no LOS says “Calc the arbitrage profit under the delta hedge scenario where prices are out of whack.”

I don’t think that particular concept is testable.