# How to price this exotic derivative with risk-neutral pricing?

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Our finance professor has given us the challenge to apply risk-neutral pricing to price an exotic derivative. The details of the question are structured in the PDF I added to this question. How would you approach this question?

1. Question 4: Risk-neutral pricing (max. 2 pages) Risk-neutral pricing has become one of the most important techniques for pricing derivatives. The approach allows to obtain no-arbitrage prices for derivatives contracts on the basis of simple assumptions for the price dynamics of the underlying asset and the risk-free rate. The approach is extremely flexible and allows to price any type of derivative. Answer the following questions: a. Illustrate the concept of risk-neutral pricing by valuing the following exotic derivative. The derivative is "European", i.e. it only pays out at the end of the contract (1 year from now). The payoff¤ of the derivative equals max(Smax - K; 0); where Smax denotes the maximum observed price between now (t) and the end of the contract (T = t + 1) and K is the strike price. The derivative hence locks in the maximum price gain above K: Consider the following situation: the current price of the asset St = 110; K = 100: Price the derivative (i.e. compute the current price of the derivative, using the binomial tree approach), on the basis of a partition of time in three levels _t = 1=3 and assuming that the upstate u(Δt = 1/3) = 1.2 and d(Δt = 1/3) = 1/1.2:Finally the gross interest rate over the interval Δt = 1/3 is given by Rf(Δt = 1/3) = 1.05. Explain your answer in detail an illustrate graphically. risk-neutral-pricing

Robert__F
School: UT Austin

Report: risk neutral pricing of derivatives

risk neutral pricing of derivatives
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Report: risk neutral pricing of derivatives

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Running head: RISK NEUTRAL PRICING OF THE EUROPEAN EXOTIC DERIVATIVE

Risk Neutral Pricing of the European Exotic Derivative
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RISK NEUTRAL PRICING OF THE EUROPEAN EXOTIC DERIVATIVE

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Risk Neutral Pricing of the European Exotic Derivative
Introduction
The risk-neutral pricing approach evaluates the price of the derivative presuming that the
derivative is bought and sold under a hypothetically fair marke...

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Anonymous
Good stuff. Would use again.

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