(Derivatives & Risk Management - Options Market Pricing Models)
Be able to explain and apply the binomial options pricing model (BOPM):
o This applies to both the arbitrage pricing version (i.e., the 5 steps version) and the risk neutral pricing version.
o What are the probabilities of the up and down state-of-nature (S.O.N.) for any given option? How does this relate to the expected moneyness of an option?
o What is the “economic story” behind the BOPM. Explain the logic and how it leads to an equilibrium price that can be enforced with the Law of One Price (i.e., how the call premium can be arbitrage enforced). There are lots of parts to this story, but remember that the foundation of this model is the concept of a replicating portfolio (aka the “partially covered call”).
o Explain why the no-arbitrage condition must exist for a call. In other words, explain what it means for a call to be over-priced or under-priced relative to the BOPM.