Real world probabilities and risk-neutral probabilities

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Question 1. A stock price has an expected return 12% per year and volatility of 25% per year. Currently the stock price is $40. Assume 252 days per year.

a) Write the equation for a log-normal stock dynamics.
b) Then write the equation for the change in stock price.
c) Then find the standard deviation of the stock price at the end of one day?
d) Suppose there is excess kurtosis of 10. What would you assume about the standard deviation? Provide 2 reasons.

Question 2. What's the difference between real world probabilities and risk-neutral probabilities? Explain the role of each in pricing derivatives. Provide at least 2 arguments

Question 3. What does Girsanov's Theorem allow us to do? Give at least 2 responses.

Reference no: EM133223692

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