I. Module 2 Homework 2 [practice]: Meet the Binomial Model
- Due No due date
- Points 4
- Questions 4
- Time Limit None
- Allowed Attempts 2
Instructions
The binomial model is really useful in asset pricing. Suppose that there are two states tomorrow,"up" and "down," and each can happen with probability 1/2. Consumption is today, in the up state and in the down state. Assume , and power utility .
This assignment introduces the binomial setup. I set it up so the payoffs are very symmetric, yet the model generates very asymmetric prices and expected returns. Ponder why.
Start by writing down a general asset pricing formula. If a payoff is and in the up and down states at time , write a formula for its price at time . Then you can do the examples that follow.