This seems simple, but I am struggling to understand how the steps in the solution are developed.
5.16 After one year, a call option may be worth either 0 or 30. The present value of the utility of 1 is .97 in the lower state and .91 in the higher state. Calculate the true annual effective rate of return on the option.
The solution:
The return is 30p, and the price is 30(.91)p, so the rate of return is
(30p)/(30(.91)p) -1 = 1/.91 -1 = .098901.
Specifically, can you please explain what formula is used in the bolded statement, or what logic is being used to achieve the bolded statement?
Thanks
5.16 After one year, a call option may be worth either 0 or 30. The present value of the utility of 1 is .97 in the lower state and .91 in the higher state. Calculate the true annual effective rate of return on the option.
The solution:
The return is 30p, and the price is 30(.91)p, so the rate of return is
(30p)/(30(.91)p) -1 = 1/.91 -1 = .098901.
Specifically, can you please explain what formula is used in the bolded statement, or what logic is being used to achieve the bolded statement?
Thanks
Exercise 5.16 from ASM Manual
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