Question

A binomial tree with one-month time steps is used to value an index option. The interest rate is 3% per annum and the dividend yield is 1% per annum. The volatility of the index is 16%. What is the probability of an up movement?

		0.4704
		0.5065
		0.5592
		0.5833

Answer 1

Correct answer: 0.5065

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

Cell reference -

Please note:

There are three parameters of Option Binomial Pricing Model

· up factor (u)

· down factor (d)

· probability (P)

up factor and down factor used to calculate rise in price and fall in price of underlying assets in one period. Probability is measure probability of rise in price and (1-P) is probability of price fall.

Cox-Rox-Rubinstein has suggested following formula to calculate these factors,

If dividend yield given:

where,

u = Price up factor

d = Price down factor

P = Probability

t= time in a period

= volatility

y = dividend yield for time in one step