State Price Deflator Sept 2011 Q7

[e_sit]

For the question, is it ok to split the split the state price deflator A_2(200) so that it is path dependent?

i.e.

The state price deflators after one year are:

if first move up, second up:
A(250)=...=0.742

if first move up, second down:
A(200)= [(0.6*0.262)/(0.75*0.25)]/(1.03^2)=0.79027

if first move down, second up:
A(200)= [(0.4*0.498)/(0.75*0.25)]/(1.03^2)=1.0014

if first move down, second down:
A(250)=...=3.004

instead of

A(250)=...=0.742
A(200)=...=0.9
A(250)=...=0.3.004

Thanks!!

 

[Graham Aylott]

For the deflator question on last September's paper (Q6) the examiners accept both approaches. So, presumably using 3 deflators (one at each node) or "splitting" the middle deflator by using two separate deflators at the middle node - one for up followed by down and another for down followed by up - should be fine in any future questions.

However, I think you've made a slight error in your calculations for the third deflator, which should be:

if first move down, second up:
A(200)= [(0.4*0.502)/(0.75*0.25)]/(1.03^2) = 1.13011

The other deflators you state are all correct though.

 

[e_sit]

For the deflator question on last September's paper (Q6) the examiners accept both approaches. So, presumably using 3 deflators (one at each node) or "splitting" the middle deflator by using two separate deflators at the middle node - one for up followed by down and another for down followed by up - should be fine in any future questions.

However, I think you've made a slight error in your calculations for the third deflator, which should be:

if first move down, second up:
A(200)= [(0.4*0.502)/(0.75*0.25)]/(1.03^2) = 1.13011

The other deflators you state are all correct though.

Thanks Graham, that was just a silly mistake!