I am new into learning option pricing and read that option pricing using binomial valuation does not depend on probabilities (real or risk neutral).


A 1 period binomial tree with $u = 1/d = 1.07$ and $S_0$ = $100.

If the up-move probability $u$ is 0.99 or 0.01, I read that the call option prices is the same and is equal to $4.8. They assumed European style options.

Can someone please help and guide me? Maybe dinner tutorial that explains this? Thanks.


What you say is false. In general, the price of an option does not depend on physical probabilities but does depend on risk neutral probabilities. In your case, in a one-period binomial tree model, the probability of going up is $q=\frac{(1+r)-d}{u-d}$ therefore the price of the option paying $C_u$ and $C_d$ is $$C=\frac{1}{1+r}\left(qC_u+(1-q)C_d\right)=\frac{1}{1+r}\left(\frac{(1+r)-d}{u-d}C_u+\frac{u-(1+r)}{u-d}C_d\right)$$ If you focus on the second part of the equation it looks like the price does not depend on probability, but as the first part shows it does indeed depend on risk-neutral probabilities!


Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.