Hello, can someone please explain the answer for question on page 5 core reading? Ques - Explain what the problem is with valuing options and guarantees using a single deterministic projection? Thanks!
This covers concepts that you would have studied in the earlier subjects. I would suggest revisiting your CM2 notes to remind yourself of what is meant by 'time value' and 'intrinsic value'. Fundamentally, if we attempt to value an option or guarantee using a deterministic method, we will obtain a single value based on the chosen set of deterministic assumptions. If we use a set of best estimate assumptions and the option / guarantee is not currently 'biting', then it will likely also not 'bite' under those assumptions, and so would be given a value of zero. This ignores the 'time value' of the option / guarantee, ie the fact that it could bite under certain future conditions. A stochastic projection would be required in order to capture those conditions.
