If the stock moves up twice, it will be worth $10 × 1.06 × 1.06 = $11.24. The probability of this occurring is 0.60 × 0.60 = 0.36. If the stock moves down twice, it will be worth $10 × (1/1.06) × (1/1.06) = $8.90. The probability of this occurring is 0.40 × 0.40 = 0.16. If the stock moves up once and down once, it will be worth $10 × 1.06 × (1/1.06) = $10.00. This can occur if either the stock goes up then down or down then up. The probability of this occurring is 0.60 × 0.40 + 0.40 × 0.60 = 0.48. Multiplying the potential stock prices by the probability of them occurring provides the expected stock price: ($11.24 × 0.36) + ($8.90 × 0.16) + ($10.00 × 0.48) = $10.27. |
