A binomial tree with threemonth time steps is used to value

A binomial tree with three-month time steps is used to value a currency option. The domestic and foreign risk-free rates are 2% and 5% respectively. The volatility of the exchange rate is 20%. What is the risk neutral probability of an up movement?

Solution

hat is the risk neutral probability of an up movement?

0.02* 0.20 + 0.05 * (1-0.20)

0.004 + 0.04

0.044

probabiity = 0.044