All, Schweser formula on size of down move is= 1/up move Where as CFA books is= 1-down move (usually given in the question). Which one is correct? Thanks for your help
The size of the down move is: D = 1/U The probability of an up move is: U = 1+Rf-D/U-D The probability of a down move is: D = 1-U
Thats the thing if you look at EOC question in CFAI book, the size of the down move is not D=1/U it is D=1-down move (given in the practice question). Where as Schweser use 1/up move. if you use schweser formula, you will not get the same answer.
We deal with options pricing at work. Binomial isn’t a tough concept once you conceptually what you’re doing. It’s essentially a tree that maps the likelihood that a stock price will go up or down. Since there are only 2 possible options, up or down, 1 - probability up = probability down and vice versa. Essentially, your getting confused by the transposition of the problem. In reality, the binomial is too general to give you and accurate view of the pricing. Trinomial models take into account the probability that the stock price will remain the same and more complex models, like the Gram-Charlier model take into account skewness and kurtosis.
Not sure what you are confused about. Here is how CFAI text calculates the binomial Stock 50. RF = 7%. Up move 25% --> Up price = 125%* 50 = 62.5 Down move = 1/125% = 80% --> down price = 50*80% = 40. Up prob = (1+ 7% - 80%) /( 125% - 80%) = 60% Down prob = 1- 60% = 40%