Thought I'd share something that some may find as a nit...I came across a question like this:
"The current price of XYZ is $20. In each of the next two years you expect the stock price to either move up 20 percent or down 20 percent. The probability of an upward move is 0.65 and the probability of a downward move is 0.35. The risk-free rate is 5 percent. .................."
I draw your attention to the boldface. Tactical exam stuff:
Here if I take U = 1.2 and D = 0.8 -- then I get one set of calculations....
However if I take U = 1.2 and then treat D = 1 / U, then D is really 0.833. This seems six-of-one and half-dozen of other, but it really isn.t
If you take D = 0.833, then S-ud = 20, as we have seen in many examples.
If you take D = 0.8, then S-ud = 19.20. These differences can be material, no?
David -- I am coming to the conclusion that if a question is phrased as: stock moves up x% or down y%, then I should not calculate D from U, but calculate D directly from the language posed in the question at the top...
Your thoughts?
--sridhar
"The current price of XYZ is $20. In each of the next two years you expect the stock price to either move up 20 percent or down 20 percent. The probability of an upward move is 0.65 and the probability of a downward move is 0.35. The risk-free rate is 5 percent. .................."
I draw your attention to the boldface. Tactical exam stuff:
Here if I take U = 1.2 and D = 0.8 -- then I get one set of calculations....
However if I take U = 1.2 and then treat D = 1 / U, then D is really 0.833. This seems six-of-one and half-dozen of other, but it really isn.t
If you take D = 0.833, then S-ud = 20, as we have seen in many examples.
If you take D = 0.8, then S-ud = 19.20. These differences can be material, no?
David -- I am coming to the conclusion that if a question is phrased as: stock moves up x% or down y%, then I should not calculate D from U, but calculate D directly from the language posed in the question at the top...
Your thoughts?
--sridhar