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The Binomial Model and Risk Neutrality: Some Important Details
Author(s) -
Nawalkha Sanjay K.,
Chambers Donald R.
Publication year - 1995
Publication title -
financial review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.621
H-Index - 47
eISSN - 1540-6288
pISSN - 0732-8516
DOI - 10.1111/j.1540-6288.1995.tb00848.x
Subject(s) - binomial options pricing model , martingale (probability theory) , econometrics , binomial (polynomial) , binomial distribution , neutrality , risk neutral measure , valuation (finance) , risk model , mathematics , economics , actuarial science , mathematical economics , valuation of options , statistics , finance , philosophy , epistemology
This paper reexamines the relationship between investors' preferences and the binomial option pricing model of Cox, Ross, and Rubinstein (CRR). It is shown that the independence of the binomial option pricing model from investors' preferences is a result of a special choice of binomial parameters made by CRR. For a more general choice of binomial parameters, risk neutrality cannot be obtained in discrete time. This analysis reveals the essential difference between the “risk neutral” valuation approach of Cox and Ross and the equivalent martingale approach of Harrison and Kreps in a discrete time framework.