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April 2003 Q9, 109

  • Thread starter SpringbokSupporter
  • Start date
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SpringbokSupporter

Member
Hi, this question seems to be talking about some exchange option. In the solution, they say the risk-free rate = 0. Does anyone know why this is the case?
 
You don't earn interest on the thing you exchange for something else.

Contrast this with a call option where we can earn interest on the cash until we (possibly) buy the share with it,

John
 
thanks sort of makes sense. If I were to price a call option relative to a risk-free asset, then would the risk - free rate still be zero?
Max{S(T) - K,0} = exp(rT)Max{S(T).exp(-rT) - K.exp(-rT) , 0)
 
The interest rate is what you earn on the thing you are about to swap. With a call option, we earn interest r on the cash. So, the interest rate used is r.
 
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