Deck 10 – Binomial Model

What do the terms $R_u$ and $R_d$ represent in the one-period binomial framework?

The stock's gross up-state and down-state returns.

How do you price a European put in a one-period binomial model once state payoffs are known?

Discount the risk-neutral expected payoff: $p_0=\frac{{\pi }_u{p}^{+}+{\pi }_d{p}^{-}}{1+r}$.

Why must a riskless hedge portfolio earn the risk-free rate in binomial pricing?

Otherwise an arbitrage opportunity would exist.

What common exam trap involves risk-neutral probabilities?

Mistaking them for actual probabilities or forecasts.