Discuss differences between the binomial option pricing model and the risk-neutral method of option pricing.

Expert Solution

Binomial option pricing model :

this is a very simple method to calculate the value of the options .the basic assumption of this model is that the markets are efficient.

this model assumes that the prices will either go up or down. specific probabilities are assigned for the price level going up or the price level going down. given the prices of the underlying securities and the strike price of an option we can calculate the pay off of the option and then discount the pay off's at the market interest rates to find the value of the option.

risk neutral method of option pricing :

in this method the pay off's calculated of the options are discounted at the risk free rate. this method of option pricing claims that there are no arbitrage opportunities available in the risk neutral market but we neither assume that the investors are risk neutral nor do we do assume that the risky assets will earn the risk free rate.

jeff jeffy answered 2 years ago

discuss the differences between the binomial option pricing model and the risk-neutral method of option pricing.

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