The Binomial Model and Risk Neutrality: Some Important Details

Sanjay Nawalkha () and Donald R Chambers

The Financial Review, 1995, vol. 30, issue 3, 605-15

Abstract: This paper reexamines the relationship between investors' preferences and the binomial option pricing model of Cox, Ross, and Rubinstein (CRR). It is shown that the independence of the binomial option pricing model from investors' preferences is a result of a special choice of binomial parameters made by CRR. For a more general choice of binomial parameters, risk neutrality cannot be obtained in discrete time. This analysis reveals the essential difference between the "risk neutral" valuation approach of Cox and Ross and the equivalent martingale approach of Harrison and Kreps in a discrete time framework. Copyright 1995 by MIT Press.

Date: 1995
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