Binominal Model for Option Values

Question 1

What is the hedge ratio?

Answer 1

It is the amount of the underlying you need to hold in order to have sufficient protection in your short position

Computation: value of call in up move - Value of call in down move / spot price in up move - spot price in down move

Question 2

what does a positive hedge ratio imply

Answer 2

In order to create a riskless portfolio, you need to hold opposite positions in the derivative and the underlying

Question 3

How do you work out call option after working hedge ratio?

Answer 3

H(Underlying) - Call option = Value

Then

Question 4

How do you replicate a call and put stock?

Answer 4

Call: Short Call + Long Underlying
Put: Long Put + Long Underlying

Question 5

What does the up move factor mean

Answer 5

If the stock rises, it goes up by X amount

Question 6

What is risk neutral probabilities

Answer 6

The probability we need to be consistent of our initial valuation

Question 7

how do you work out the down move

Answer 7

1 / UP move

Question 8

how do you work out risk neutral probability of up move

Answer 8

1+Rf - Down move / Up - Down mov

Question 9

how do you work out risk neutral probability of down move

Answer 9

1 - Risk Neutral Proability of down move

Question 10

Value of Option calculation

Answer 10

= PV of expected payoff
Pay off = Probability * Payodd