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CFA Level I · CFA Level I Exam · Pricing and Valuation of Options

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

The risk-neutral probability is the probability that makes the expected underlying value, discounted at the risk-free rate, equal today's price. It is a pricing device, not a real-world or subjective forecast, and it is not the actual probability of finishing in the money.

  1. Athe probability that the call finishes in the money
  2. Ba probability that makes the expected discounted underlying return equal the risk-free rateCorrect
  3. Cthe investor's subjective estimate of the likelihood of an up move

Explanation

Risk-neutral probabilities are those that make the expected value of the underlying, discounted at the risk-free rate, equal to its current price. They are not real-world probabilities or subjective estimates, and they do not give the actual chance of finishing in the money.

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