BUS 316 Lecture Notes - Risk Neutral, Arbitrage
31 May 2014
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H (we may also use the notation price and. Then the binomial formula is as follows: is the price of a derivative security. We take it as the solution of the equation. In other words, eq. (bin. 1) is being calibrated to the stock. W! as being observed in the market, and in (1) we binomial formula is satisfied by for other securities. We also note that eq. (bin. 1) is satisfied by a bond paying at time 1. On the other hand, the binomial formula gives. Suppose we create a portfolio of the bond, the stock and another security. For example, at time 0 we hold 3 bonds, 5 shares of stock and 20 calls. Given that each one of them satisfies the risk-neutral-valuation equation (bin. 1), it follows algebraically that the same is true for the portfolio. A portfolio of securities, all of which satisfy property satisfies this property. Conclusion: the risk-neutral pricing method is c requirement of no-arbitrage.
