Chapter 17, flashcard 9 states that market-consistent investment rate can be risk-free rate, but volatility must be based on actual underlying investments. Why this inconsistency?
The reasons for this are discussed in Subject CT8. The easiest way to remember it is by considering the Black-Scholes equation, which gives us a market-consistent price for options. The equation uses the volatility of the underlying share (so will be different if we consider a different share) but always uses the risk-free rate (so does not use the expected return from the share). Best wishes Mark
