Risk Neutrality

 Investors are risk-neutral. They would simply

expect a risk-free rate of return. In our example,
the share price could rise by 100 per cent (from
Rs 150 to Rs 300) or it could fall by 33.3 per cent
(from Rs 150 to Rs 100). Under these situations, a
risk-neutral investor’s return from the investment
in the share is given in box.

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 Risk Neutrality
 We can utilise this information to determine
the value of the call option at the end of the
year. The call option is worth Rs 100 when the
share price increases to Rs 300, and its worth
is zero if the share price declines. We can thus
calculate the value of the call option at the end
of one year as given below:
 Value of call option at the end of the period
= 0.325´ 100 + (1 – 0.352)´ 0 = Rs 32.50
 Current value of the call option
= 32.5/1.1 = Rs 29.55
Expected return  (probability of price increase)  percentage increase in price
 (1  probability of price increase)  percentage decrease in price  risk-free rate
 p  100  (1  p)  (33.33)  10
p  0.325
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