Risk-Neutral Probabilities and Dynamic Replication

In simple, one-period binomial models for option pricing, the assumption is that the underlying stock of the option will only change price once before the option matures. This unrealistic assumption has driven the development of the concept of dynamic replication, changing the structure of the portfolio that defines the option, to better correspond to underlying price movements. While dynamic replication is a robust concept, it is very challenging computationally. To compensate for this challenge, option users can engage the concept of risk-neutral probabilities in option pricing. In this weeks Discussion, you will critically assess the challenges associated with the implementation of dynamic replication and discuss the intuition behind risk-neutral probabilities.

To Prepare: Review this weeks Learning Resources, as well as other resources you may access from the Internet. Consider the following: What parts of dynamic replication make it challenging to use for option pricing? Is there any way to simplify the process of dynamic replication without significant compromises on option price accuracy? Are risk-neutral probabilities conceptually related to the real world?

Post by Day 3 a 3- to 6-paragraph critical evaluation of dynamic replication and risk-neutral probabilities in option pricing. Make sure to include responses to the following specific questions:

#1 To what extent do you expect that dynamic replication is actually used and by what type of users (banks, hedge funds, speculators, etc.)?

#2 What do you find most challenging in the concept of dynamic replication? Explain your choice clearly.

#3 Beyond option pricing, can you suggest a business scenario that would benefit from the use of risk-neutral probabilities? Provide a clear example.

Clearly address each of the questions with 12 paragraphs. Make sure you use APA style for your response(s) and properly cite any resources you have used.