Suppose you are given the following data:
€¢ Risk-free yearly interest rate is r = 6%.
€¢ The stock price follows:
St ˆ’ Stˆ’1 = μSt + σStεt
where the εt is a serially uncorrelated binomial process assuming the following values:

The 0 €¢ Volatility is 12% a year.
€¢ The stock pays no dividends and the current stock price is 100.
Now consider the following questions.
(a) Suppose μ is equal to the risk-free interest rate:
μ = r
and that the St is arbitrage-free. What is the value of p?
(b) Would a p = 1/3 be consistent with arbitrage-free St?
Now suppose μ is given by:
μ = r + risk premium
(c) What do the p and εt represent under these conditions?
(d) Is it possible to determine the value of p?

Transcribed Image Text:

+1 with probability p 1 with probability 1 p