FBE559.slides.07

# This security is very correlated with the market high

This preview shows page 1. Sign up to view the full content.

This is the end of the preview. Sign up to access the rest of the document.

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...
View Full Document

## This document was uploaded on 10/28/2013.

Ask a homework question - tutors are online