Question

Suppose that risk-averse investors expect the return on a stock to be µ per annum and the risk-free rate is r per annum. In a binomial tree, if µ < r, the real probability of an increase in the stock price is lower than the risk-neutral probability of the increase.

(a) True

(b) False

Answer 1

False

Increase in the stock price cannot be estimated on the basis of risk- averse or risk-free investor.

Changes in stock price has its own probabilities and combinations, it can either be Lower or higher than the risk-neutral graph.

Therefore the above statement is false.

Below are some terms explanation for better understanding

Risk-averse- Risk averse is a term wherein an investor is a risk lover over gains, the probability of return is fluctuating.

Risk-free- Returns under this term is fixed, there's no risk under such stocks.

Risk neutral- Risk neutral is a term where in an investor will choose gains on a stock rather than risk attached to it.