RIsk-neutral probability

CFA Level II Derivatives
#1

If it’s not given in the problem with binomial trees, how to udnerstand whether to calculate risk neutral probability or just use probability of 0.5?

#2

Depends… is it an options binomial problem? If it is you calculate it with the up/down and rush free rates.

#3

sorry, not clear. if it’s options binomial then i should calculate probability myself and if it’s just with price nods without options embedded then not?

#4

Use risk-neutral probabilities with bonds with embedded options.

#5

Nope.

#6

For interest rate trees, use 0.5 for the up move and 0.5 for the down move. You’ll then need to calibrate the interest rates in the tree. Use these trees for calculating bond values, the value of options embedded in bonds, calculating OAS, and so on.

For price trees, you’ll decide what the up and down prices are, then calculate the risk neutral probabilities (i.e., weights). Use these trees for valuing options on stocks.

#7

Good to know.

#8

I’ll mention you in my prayers

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