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No more replicating portfolios : a simple convex combination to understand the risk-neutral valuation method for the multi-step binomial valuation of a call option

Listed author(s):
  • Roger MERCKEN


    (Hasselt University, Faculty of Business Economics, KIZOK)

  • Lisette MOTMANS


    (Hasselt University, Faculty of Business Economics, KIZOK)

  • Ghislain HOUBEN


    (Hasselt University, Faculty of Business Economics, KIZOK)

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    This paper covers the valuation, from beginning to implementation, of a European call option on a stock using the multi-step binomial model in a risk-neutral world. The aim is to introduce this model in a simple but rather unconventional way. The usual presentation of the risk-neutral valuation, see Hull (2009),among others, relies on replicating portfolios. For most practitioners, this technique looks rather mysterious. We present a new transparent analysis requiring no replicating portfolios. The new finding to understand why the risk-neutral pricing is consistent with investors being risk-averse is the notion of a convex combination.

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    Article provided by Danubius University of Galati in its journal Euroeconomica.

    Volume (Year): (2010)
    Issue (Month): 24 (March)
    Pages: 64-71

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    Handle: RePEc:dug:journl:y:2010:i:24:p:64-71
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    1. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
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