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Thread: derivative valuation question

  1. #1
    Senior Member
    Nov 2010
    Hong Kong

    derivative valuation question


    Let V be the value of a derivative written on an asset whose time t=o value is S and whose value in the next period at time t=1 will be Su or Sd, where d<1=r<u and r is the interest rate for the period. Suppose the derivative value in the next period is correspondingly V_u and V_d. Show by constructing an appropriate portfolio that


    The background to this question is a chapter in Mathematics for Finance and Valuation entitled "One period, one risky asset and two states" where the risk-neutral probability was introduced and used to value the forward contract and call and put options.

    I cannot get to that equation. My attempt at solution:

    First, I find state probabilities (eg q_u is the probability of "up" state and so on) from the current price of asset S:

    Suq_u+Sdq_d=S<br />

    Suq_u+Sd(1-q_u)=S eliminate S




    Then I assume I can use the same probabilities to value the derivative claim on the asset S (can I?). The value of the derivative in one year's time V(1+r) should be


    So my answer is different from the instruction by one component: I have V_du and they have V_dd. Any comments?

    Another question, does interest r=1 make sense?... Is that 100%?
    Last edited by Volga; Jan 8th 2011 at 06:25 AM.
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