Going through exam questions, I've found two formulae used in State Price Deflator questions: 1. Au.p + Ad(1-p) = e^(-r) 2. An = e^(-rn). (q/p)^Nn . [(1-q)/(1-p)]^(n-Nn) Under what circumstances should we used each formula? The second formula seems to be used when we have a question involving a two-period binomial tree. Thanks.
SPDs are stochastic discount factors The fair price of any asset = Sum over possible final share prices of.... Discount factor * Payoff * Probability If using real-world probabilities, use SPDs as your discount factor If using risk-neutral probabilities, use the risk-free rate as your discount factor So, in a qustion you would use whatever information you can to calculate the value of the SPD Good luck! John
