Comparing Risk-Neutral and Real Probabilities in the Binomial Model: Practice Problems and Solutions

The Actuary's Free Study Guide for Exam 3F / Exam MFE - Section 26

This section of sample problems and solutions is a part of The Actuary's Free Study Guide for Exam 3F / Exam MFE, authored by Mr. Stolyarov.

This is Section 26 of the Study Guide. See Section 1 here. See Section 2 here. See Section 3 here. See Section 4 here. See Section 5 here. See Section 6 here. See Section 7 here. See Section 8 here. See Section 9 here. See Section 10

here. See Section 11 here. See Section 12 here. See Section 13 here. See Section 14 here. See Section 15 here. See Section 16 here. See Section 17 here. See Section 18 here. See Section 19 here. See Section 20 here. See Section 21 here. See Section 22 here. See Section 23 here. See Section 24 here. See Section 25 here.

In a risk-neutral situation, the risk-neutral probability of the stock price increasing during a period of the binomial model must satisfy this equation:

(p*)uSe^δh + (1-p*)dSe^δh = Se^rh

With real probabilities, for a stock that does not pay dividends,

puS + (1-p)dS = Se^αh

Meaning of variables:

S = underlying asset (stock) price.

p* = (e^(r-∂)h - d)/(u - d) = risk-neutral probability of stock price increase.

p = true probability of stock price increase.

u = 1 + rate of capital gain on stock if stock price increases.

d = 1 + rate of capital loss on stock if stock price decreases.

h = one time period in binomial model.

∂ = annual continuously-compounded dividend yield.

α = the annual continuously compounded expected return on the stock.

Thus, the formula is as follows for p:

p = (e^αh - d)/(u - d)

There is a constraint that enables the value of p to always be between 0 and 1:

d < e^αh < u

Problem SPURNRPBM1. The price of Deleterious Co. stock, which does not pay dividends, will change by a factor of either 1.5 or 0.4 in 2 years. Find the upper constraint on the annual continuously compounded expected return on the stock.

Solution SPURNRPBM1. We use the inequality d < e^αh < u, where we want to find the upper bound on α, given that e^αh < u. This upper bound X occurs when e^Xh = u or

X = ln(u)/h. Here, u = 1.5 and h = 2, so X = ln(1.5)/2 = X = 0.2027325541

Problem SPURNRPBM2. The price of Deleterious Co. stock, which does not pay dividends, will change by a factor of either 1.5 or 0.4 in 2 years. The annual continuously compounded expected return on the stock is 0.05. Find the real probability that the stock will increase in price in two years.

Solution SPURNRPBM2. We use the formula p = (e^αh - d)/(u - d), where u = 1.5, d = 0.4, h = 2, and α = 0.05. Thus, p = (e^0.05*2 - 0.4)/(1.5 - 0.4) = p = 0.641064471.

Problem SPURNRPBM3. Imperious LLC stock will change by a factor of either 1.9 or 0.2 in h years. The stock pays dividends on a continuously compounded basis with annual yield of 0.06. The annual continuously compounded rate of interest is 0.09. The risk-neutral probability of the stock price's increase in h years is 0.72. Find h.

Solution SPURNRPBM3. To find h, we will need to use the formula

p* = (e^(r-∂)h - d)/(u - d)

We can simplify p* using the values given for u = 1.9, d = 0.2, r = 0.09, and δ = 0.06, so (r - δ) = 0.03. Thus,

p* = 0.72 = (e^0.03h - 0.2)/1.7. Thus, e^0.03h = 1.7*0.72 + 0.2 = 1.424 and h =

ln(1.424)/0.03 = h = 11.7823271 years.

Problem SPURNRPBM4. You live in a risk-neutral world, and just purchased a share of Lucrative Co. stock at a price of $1000. You do not know the annual continuously compounded risk-free interest rate (who does, in reality?), but you do know that the stock pays dividends with an annual continuously compounded yield of 0.12. You also plan to hold the stock for 13 years, at the end of which it will be either 3.4 or 0.1 of its present price. The risk-neutral probability of a stock price increase is 0.82. You could have invested the $1000 for 13 years in an account earning the annual continuously compounded risk-free interest rate. What would your account balance be at the end of 13 years if you did so?

Solution SPURNRPBM4. We use the formula (p*)uSe^δh + (1-p*)dSe^δh = Se^rh, where we desire to find Se^rh. We are given that p* = 0.82, u = 3.4, d = 0.1, h = 13, ∂ = 0.12, and S = 100. Thus, Se^rh = 0.82*3.4*1000e^0.12*13 + 0.18*0.1*1000e^0.12*13 = Se^rh = $13276.15951

Problem SPURNRPBM5. At t =13 years, Lucrative Co. stopped paying dividends on its stock, and everybody suddenly became risk-averse. Lucrative Co. also changed its name to Not-So-Lucrative Co. In another 10 years, its stock price will change by a factor of 1.3 or by a factor of 0.3. You take $13276.15951 and you invest it in Not-So-Lucrative Co. stock, knowing that the real probability of the stock price increasing over that time period is 0.76. You could have invested the $13276.15951 for 10 years in an account earning a return equal to the annual continuously compounded expected return on the stock, but you do not know what that return is. What would your account balance be at the end of 10 years if you did so?

Solution SPURNRPBM5. We use the formula

puS + (1-p)dS = Se^αh, where we desire to find Se^αh. We are given that p = 0.76, u = 1.3, d = 0.3, S = $13276.15951 (for all practical purposes, we can consider this the price of one share). Thus, Se^αh = 13276.15951[0.76*1.3 + 0.24*0.3] = Se^αh = $14072.72908

See other sections of The Actuary's Free Study Guide for Exam 3F / Exam MFE.