Consider a Binomial Tree Setting in Which in Each Period $u > 1$

question 9

Multiple Choice

Consider a binomial tree setting in which in each period the price goes up by $u > 1$ (with probability $p$ ) or down by $d < 1$ (with probability $1 - p$ ) . The risk-free interest rate per time step is zero, so a dollar invested at the beginning of the period returns a dollar at the end of the period. In this setting, the risk-neutral probability of an at-the-money two-period put finishing in-the-money is _____________ as that of a one-period at-the-money put finishing in-the-money.

• A) At least as high.
• B) At most as high.
• C) Equal to.
• D) More than one of the above is possible depending on the parameters.

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Definitions:

Cost of Equity

The return a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing their capital.

WACC

Weighted Average Cost of Capital, a calculation of a firm's cost of capital weighted by each category of capital, including equity and debt, reflective of the risk and cost of each type of financing.

Project Risk

Involves the uncertainties and potential losses associated with investing in a specific project due to various factors including market demand, regulatory changes, and technological challenges.

Debt Rating

An assessment of the creditworthiness of a debtor, usually in the form of a code or letter grade, provided by credit rating agencies.