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CFA Level I · CFA Level I Exam · Valuing a Derivative Using a One-Period Binomial Model

Compared with pricing an option using real-world probabilities of up and down moves, the risk-neutral approach in a one-period binomial model most likely:

The risk-neutral approach gives the same value as no-arbitrage replication. Its probabilities are derived from the up and down factors and the risk-free rate, so investor risk aversion and the underlying's expected return are not needed.

  1. Arequires an estimate of investors' risk aversion
  2. Bgives the same value as no-arbitrage replicationCorrect
  3. Cdepends on the expected return of the underlying

Explanation

Risk-neutral probabilities are built from u, d and the risk-free rate, so the discounted expected payoff equals the cost of the replicating portfolio. Neither risk aversion nor the underlying's expected return is needed.

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