Caliberating binomial models in Chapter 13

Discussion in 'CT8' started by padasala, Jan 11, 2016.

  1. padasala

    padasala Ton up Member

    Hi,

    i have a question on the distributional assumption made.

    In chapter 13 (section 6), the main assumption that is made is that the rate of return on the stock at time t from reference time t0 is log-normally distributed.

    However, they make a statement that this is the case "under risk-neutral law". In a risk neutral world, wont the rate of return expected by investors remain the same?

    I referred to John C Hull on risk neutrality and this is what it had to say:"This states that, when valuing a derivative, we can make the assumption that investors are risk-neutral. This assumption means investors do not increase the expected return they require from an investment to compensate for the increased risk"

    What I take from this is that every security will have the same rate of return. Then why do we make the distributional assumption?

    Sorry for the long post :)

    Regards,
    Sunil
     
    Hemant Rupani likes this.
  2. Hemant Rupani

    Hemant Rupani Senior Member

    Expected rate of return remains \(exp(r\delta t) - 1\) , which is independent of risk/volatility.
     

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