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#1
06-29-2012, 03:13 PM
 troyandabed Member CAS Join Date: Oct 2011 Location: Air Conditioning Repair Annex Studying for MFE Favorite beer: Red Oak Posts: 370
Expected Return on Option

I'm working problem 11.7 in Derivatives Markets using the spreadsheets that come with the text. I've computed an option price of 15.9622 for a European call at the left-hand most node (start of the tree), and have an expected stock return of 15%. This is a binomial tree problem with 10 steps.

If I want to calculate the expected return on the option do I use the option prices at the two nodes to the right in the binomial tree according to formula 11.7 in the book? I'm not sure if the computed value of gamma at this node will be the overall expected return on the option. The book doesn't seem to explain that point at all.
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Last edited by troyandabed; 06-29-2012 at 03:16 PM..
#2
06-29-2012, 03:38 PM
 MusaAli Member CAS SOA Join Date: Nov 2011 Posts: 106

umm... how do i put this? it's like this...

Keep in mind that the whole binomial tree is a chart of POSSIBILITIES. they are in fact, expected prices aren't they? and u build this chart based on ur expected probabilities and rates of return. the realized returns have no place here.

So that said, i hope u realize that we use the expected return and the value of two right nodes to price a node right? so if u know the value of the node and the 2 right nodes, u use these three values to find out what return was expected (or assumed) when we obtained the price of this node. get it?

Hope it makes sense....
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