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

In a one-period binomial model for pricing a European call, the risk-neutral probability of an up move is most likely interpreted as:

The risk-neutral probability is the up-move probability that makes the expected underlying value, discounted at the risk-free rate, equal today's price. It is a pricing device derived from no-arbitrage, not a forecast of actual real-world likelihood or a measure of risk aversion.

  1. Athe real-world probability that the stock rises, estimated from historical returns
  2. Ba probability that makes the expected discounted underlying equal its current priceCorrect
  3. Cthe probability that the call finishes in the money, reflecting investor risk aversion

Explanation

The risk-neutral probability is derived so that the underlying's expected payoff discounted at the risk-free rate equals its current price. It is not a real-world or risk-aversion-based probability.

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