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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, 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 discounted expected underlying price equal to its current price at the risk-free rate. It is a pricing construct, not the real-world probability or the chance of the option finishing in the money.

  1. Athe probability that investors actually assign to the up move in the real world
  2. Ba probability that makes the expected underlying value at expiration, discounted at the risk-free rate, equal to its current priceCorrect
  3. Cthe probability that the option finishes in the money at expiration

Explanation

The risk-neutral probability is a device chosen so that the expected future underlying price discounted at the risk-free rate equals today's price. It is not the real-world probability and not the probability of finishing in the money.

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