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

Anonymous
timer Asked: Dec 29th, 2018
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Question description

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

Tutor Answer

Robert__F
School: UT Austin

Please let me know if there is anything needs to be changed or added. I will be also appreciated that you can let me know if there is any problem or you have not received the work Good luck in your study and if you need any further help in your assignments, please let me know Can you please confirm if you have received the work? Once again, thanks for allowing me to help you R P.S: Studypool is facing high level of traffic which may delay the downloading process. MESSAGE TO STUDYPOOL NO OUTLINE IS NEEDED AS IT IS A DISCUSSION COMPLETED 100%

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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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1

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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