Suppose that the stock price is stochastic (say, lognormal) with constant volatility, and that the interest rate, though not stochastic changes from period to period on the tree. Which of the following statements is valid?
A) The stock process may be represented by a CRR binomial tree and it will be recombining.
B) The stock process may be represented by a JR binomial tree and it will be recombining.
C) Both (a) and (b).
D) Neither (a) nor (b).

Question

Quizplus · Accepted Answer

A CRR binomial tree assumes a constant interest rate, but allows for a stochastic stock price with constant volatility. The tree is also recombining, meaning that the same set of possible future outcomes can be reached by different paths. The JR binomial tree, on the other hand, assumes a constant interest rate and a stochastic stock price with variable volatility. Therefore, option B is not valid.

Suppose That the Stock Price Is Stochastic (Say, Lognormal) with Constant