A tree is constructed to value an option on an index which is currently worth 100 and has a volatility of 25%. The index provides a dividend yield of 2%. Another tree is constructed to value an option on a non-dividend-paying stock which is currently worth 100 and has a volatility of 25%.
A) The parameters p and u are the same for both trees
B) The parameter p is the same for both trees but u is not
C) The parameter u is the same for both trees but p is not
D) None of the above

Question

Quizplus · Accepted Answer

The up factor (u) is determined by volatility and is the same for both trees, but the probability (p) differs due to the dividend yield affecting the risk-neutral probabilities.

A Tree Is Constructed to Value an Option on an Index