To create a delta-neutral portfolio, the SIT fund has sold 10,000 put options on Epsilon stock with a strike price of $80 when the shares were trading at $100. The risk manager from SIT uses the Black-Scholes model to value all its option exposures. The current price of the shares is $90. The annualized standard deviation of Epsilon stock returns is 40% and the option expires in six months. If the risk-free rate is 2%, approximately, what is the likelihood that this option will be exercised? (a) 0.7975 (b) 0.6219 (c) 0.3781 (d) 0.2025
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
To create a delta-neutral portfolio, the SIT fund has sold 10,000 put options on Epsilon stock with
a strike price of $80 when the shares were trading at $100. The risk manager from SIT uses the
Black-Scholes model to value all its option exposures. The current price of the shares is $90. The
annualized standard deviation of Epsilon stock returns is 40% and the option expires in six months.
If the risk-free rate is 2%, approximately, what is the likelihood that this option will be exercised?
(a) 0.7975
(b) 0.6219
(c) 0.3781
(d) 0.2025
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