In the spirit of Dinesh’s question earlier, I made up this little brain teaser to start the evening off right. Relating to the single stage binomial options pricing model: Given a stock price of $100, a risk free rate of .08, a potential down movement to $83, and a potential upward movement to $108, what is the probability of a downward (1 minus PI) move to use in your calculations? A) 83% B) 65% C) 17% D) 0%
C or D?
c? I hate made-up questions as much as the real ones…
The answer is D. Formula is: P(U) = [1 + r(f) - D] / [U - D] P(D) = 1 - P(U) Where U and D are up and down percentages, respectively. I think it is insightful into the nature of the model that if the Up move equals the risk free rate, there is a 100% probability an up move. As the Up gets further away from the risk free rate, the probability of an up move decreases. Hope this helped someone remember this key formula.
<> Yep that is what I figured too!! At last something is right for me, even if it is only a made up question!! Thanks Dwight!!
thanks dwight…that is insightful… always had trouble remembering this stupid formula…will do so now!