Multiple step binomial model doubt

Discussion in 'CWA' started by diya, Jan 8, 2014.

  1. diya

    diya Member

    Please explain how to calculate the prob of price limits of FP1 and FP2 in the following Multiple Step Binomial Model problem Q) A stock is currently priced at Rs50. It is known that in the first 6 months of current year from now prices will either rise by 20% or go down by 20%, further in the later half of the year prices may again go up by 20% or go down by 20% in the second step. Suppose risk free interest rate is 5% continuous compounding and strike rate is Rs52. Calculate value of European Put Option. ( my doubt is only regarding the computation of probabilities of price limits for each step--in the exercise it is shown as FP1=0.50 and FP2=0.50. However using the formula Probability of lower price limit = (u-f)/(u-d) and Probability of higher price limit = f-d/u-d the probabilities are different that what is shown in the exercise i.e 0.50.)

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