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A company is currently the possible target of a hostile takeover which is expected to become...

A company is currently the possible target of a hostile takeover which is expected to become public within two months. The stock price is currently $36. If the hostile takeover happens, the stock price is expected to be $48 at the end of two months. If the hostile takeover does not happen, it is expected to be $28 at the end of this two month time period. The two-month risk-free interest rate is 6% per annum. What is the risk-neutral probability of a positive outcome?

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Answer #1

Su = Expected Upward Price after 2 months / Current Price = $48/36 = 1.3333

Sd = Expected Downward Price after 2 months / Current Price = $28/36 = 0.7778

What is the risk-neutral probability of a positive outcome?

risk-neutral probability of a positive outcome = (1 + 2 month Interest Rate - Sd) / (Su - Sd)

risk-neutral probability of a positive outcome = (1 + 0.005 - 0.7778) / (1.3333 - 0.7778)

risk-neutral probability of a positive outcome = 0.2272 / 0.5556

risk-neutral probability of a positive outcome = 40.90%

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