Chapter 12: Introduction to Binomial Trees

Question 1

What is risk neutral valuation?

Answer 1

This assumption means investores do not increase the expected return they require from an investment to compensate for increased risk.

Question 2

2 features of a risk-free world:

Answer 2

1) The expected return on a stock (or any other investment) is the risk-free rate. 2) The discount rate used for the expected payoff on an option (or any other instrument) is the risk-free rate.

Question 3

E(St) =

Answer 3

S0e^rT

Question 4

(T/F) A position in a call option is riskier than a position in the stock

Answer 4

True

Question 5

Delta

Answer 5

the ratio of the change in the price of the stock option to the change in the price of the underlying stock. It is the number of units of the stock we should hold for each option shorted in order to create a riskless portfolio.

Question 6

What is “delta hedging”

Answer 6

The construction of a riskless portfolio.

Question 7

Delta of a call is positive (T/F)

Answer 7

True

Question 8

Delta of a call is negative (T/F)

Answer 8

False

Question 9

Delta of a put is positive (T/F)

Answer 9

False

Question 10

Delta of a put is negative (T/F)

Answer 10

True

Question 11

How to find “u”

Answer 11

e^(volatility*Sqrt(DeltaT))

Question 12

How to find “d”

Answer 12

1/u

Question 13

What is delta T?

Answer 13

the length of one time step on a binomial tree

Question 14

In a world with no arbitrage opportunities, ________ portfolios must earn the ____-____ rate of interest

Answer 14

riskless; risk-free

Question 15

(T/F) No assumptions are required about the actual (real-world) probabilities of up and down movements in the stock price at each node of the tree.

Answer 15

True