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

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Expert Solution

Binomial option pricing model is a model for finding the price of an option. We can say Binomial model is derived from risk neutral method of option pricing. It is one of many ways through which Binomial pricing model can work.

Under risk neutral method of option pricing; we equate the expected payoff of a call option to the risk free rate of return. Through this we will find the probability of an upmove and probability of down move in a stock which can give an expected return which is same as risk free return.Risk neutral method is a generic approach and it can be also used to find the valuation of other derivatives like futures and forward contract.

Whereas Binomial model can be made mainly by 3 approach.

Risk neutral method
Delta heding approach
Replicating portfolio approach

As we can see, risk neutral method is one of the ways by which we can implement Binomial option pricing.

Thus Risk neutral probability is a concept/approach that is generic and Binomial option pricing model is its application specific to options.

jeff jeffy answered 1 year ago

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