FBE559.slides.07

This security is very correlated with the market high

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Unformatted text preview: s than the expected payoff of .3/1.025? Answer: Less. Example (continued) Why should it be worth less then its expected discounted value? This security is very correlated with the market High β ⇒ high expected return according to CAPM. It pays you money exactly when you least need it. So it costs less than .3/(1 + r ). Say that it costs .26/(1 + r ). .26 reflects the risk-neutral probability The average return is: .3 − 1.26 E [payoff] − price .025 = = 18.3% .26 price 1.025 If the price was .3, then the expected return would be 2.5% or just the riskless-rate. Connecting Risk-Neutral and Actual Probabilities Notice, if we knew 1 The actual probability 2 The expected return (which reflects risk premia) we could compute the risk-neutral probability. What about the security that pays in the “down” state? S0 0 1 Since probabilities sum to 1: the risk-neutral probability of down is 0.74 Remember if you buy down+up you get $1 for sure and we that assumed up costs 0.26/1.025 This...
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