Question 1

For pricing purposes how important is it to know the true probabilities?

Accepted Answer

It is not important to know the true probabilities, as long as they are consistent. This is shown by the fact the we use risk neutral probabilities to price, knowing that they are not the true (risk natural) probabilities.

Question 2

What is risk neutral pricing?

Accepted Answer

Risk neutral pricing means to deliberately modify the probabilities on a tree or model, in order to set the market price of risk to zero. This simpliﬁes the calcualations made when pricing securities.

Question 3

What is the market price of risk underlying the tree presented?

Accepted Answer

The answer of What is the market price of risk...

Question 4

Assuming that there is a risk premium in the market (people worry about risk and expect to be compensated for it), is risk neutral probability for an up state (high interest rates) higher, lower or the same as the risk natural probability?

Accepted Answer

The answer of Assuming that there is a risk premium...

Question 5

You are given the following interest rate tree. Use it when required in the
exercises. 
-What is the favored approach in the development of interest rate models? CAPM?

Accepted Answer

The answer of You are given the following interest rate...

Question 6

What is a risk neutral probability?

Accepted Answer

The answer of What is a risk neutral probability? ...

Question 7

What values can a one year zero coupon bond take at t =0.5?

Accepted Answer

The answer of What values can a one year zero...

Question 8

What is the risk neutral probability p∗ ofthetreepresented?

Accepted Answer

The answer of What is the risk neutral probability p∗...

Question 9

Why are forward interst rates and the risk neutral expected future interest rates not the same?

Accepted Answer

The answer of Why are forward interst rates and the...

Question 10

Using risk neutral pricing obtain the value for a European option on inter- est rates with maturity at t =0.5, rK =1.5% and payo?: 100 × max(rt ? rK, 0).

Accepted Answer

The answer of Using risk neutral pricing obtain the value...

Question 11

Are forward interest rates equal to the market's expectation of future interest rates?

Accepted Answer

The answer of Are forward interest rates equal to the...

Question 12

from a given risk neutral tree can you compute the mar- ket participants' expectation on the level of interest rates in the future? Explain.

Accepted Answer

A) True 
 B)False

Question 13

You are given the following interest rate tree. Use it when required in the
exercises. 
-What is a replicating portfolio?

Accepted Answer

The answer of You are given the following interest rate...

Question 14

Given the tree at the begining of this chapter, what is the value of a zero coupon bond maturing in six months?

Accepted Answer

The answer of Given the tree at the begining of...

Question 15

What is the market price of risk?

Accepted Answer

The answer of What is the market price of risk?...

Exam 9: One Step Binomial Trees