Risk-Neutral Probabilities and Dynamic Replication In simple, one-period binomia

Question

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.

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: To what extent do you expect that dynamic replication is actually used and by what type of users (banks, hedge funds, speculators, etc.)? What do you find most challenging in the concept of dynamic replication? Explain your choice clearly. 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 1–2 paragraphs. Make sure you use APA style for your response(s) and properly cite any resources you

Explanation / Answer

In the initial phase, as a pilot implementation, there is probability that it would be used by 5-10% of the market participants and if successful; it could be used by banks, financial institutions, hedgers, mutual funds houses and broking agencies at a larger level. As mentioned above it is challeging computationally and it may face technical glitches often as the concept is new at the moment. It may face security/trust issues which may result in frauds/scams. It will take time to stabalize and gain acceptance amongst market participants. Beyond options pricing, it can be replicated in futures trading for stocks, bonds, forex & commodities. If successful, it can be implemented for taking positions in interest rate swaps too.

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