How To Estimate u, d and

p?

 The value of option in binomial model

depends on the value of risk-neutral
probability, p
The value of p depends on the
estimates of the up-move & downmove, u & d respectively
How should we estimate u, d & p?

Extensions of Binomial
A. Inputs: stocks expected return () &
volatility ()
B. Time step: t
C. Given the inputs in A the volatility
during time
t =
step
t

 Step 1: Expression for expected stock price

using real world probabilities (p*)
Step 2: Equating step 1 with expected stock
price based on its expected return & time
interval t
Step 3: Deriving the value of p* (11.11)
Step 4: Expression for variance of stock
return based on the real world binomial tree
Step 5: Equating Step 4 to variance over t
(11.12)

 Step 6: Substituting for p from 11.11 into

11.12
Step 7: Solution to the equation in Step 6 by
ignoring the terms t2 & higher powers this
gives the values of: u & d: 11.13 & 11.14
Step 8: Expressions for estimating the value
of p (the risk-neutral probability of up-move):
11.15 & 11.16
Example 1: Estimation of u, d & p (Hull/p271)