Page 11 - Study Notes - Hull Chapter 13 - Binomial Trees

[Dr. Jayanthi Sankaran]

Hi David,

As referenced above, and as also mentioned in Hull:

When using a binomial tree to represent the movement in the price of the underlying, the


parameters u and d are chosen so as to match the volatility of the stock price. It turns out


that the volatility is the same in both the real world and the risk-neutral world. So even


though the probabilities of up and down moves differ, and the expected return on the stock


depends on whether we are in a real world or risk-neutral world, the volatility does not.

Is it necessary to know the above derivation as in Hull for exam purposes or just the underlying concept?

Thanks!
Jayanthi

 

[David Harper CFA FRM]

@Jayanthi Sankaran you certainly do not need to know the derivation (it's in Hull and certainly not profound, but it is tedious) but the FRM exam has asked about the up (u) and down (d) given volatility, so I do recommend knowing (memorizing) that u = exp[σ*sqrt(ΔT)] and d = 1/u. Thanks!

 

[Dr. Jayanthi Sankaran]

Yes, it is certainly not profound!