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.
