Question

1.How does the binomial option pricing model improve upon the two-state model? (2 pts.)

2. What is the alpha of a security and what is it used to measure or judge? (2 pts.)

Please answer both!

Answer 1

1. Two state model is also one of the kind of binomial model of option pricing model, where as in two state model value of call option is calculated on the basis of two future prices of the stocks.

by using two state model whether a portfolio is risk free or not can be stated, arbitrage among 2 states can be calculated and the best resulted call option can be exercised assume s1 and s2 are the future prices of the stock

call = s1- stock price at present

by using the binomial option pricing model. Option price can be calculated at any time needed and dividends of the stock can be considered and for long duration can be considered where as same does not apply with two factor model. Binomial option pricing model can be used to pricethe american options and burmidan options.

2. alpha or jensen's alpha is origined on the basis of CAPM model ny considering the risk free rate and the market risk.

alpha value for a stock mentions how much over and above returns that the stock is churning from the market index. If the value of alpha is positive the stock is doing better than the market if value is more than 1. Negative aplha represents stock is going is opposite direction of the market

alpha value could be negative, positive and 0

By conaidering hiatorical alpha value it is judged whether investing in the stock