2
$\begingroup$

I am self-studying models for financial economics and encountered the following problem:

enter image description here

I don't see how the author can conclude that $\gamma = -0.62$. Let's rearrange the second to last equation: $$\gamma - r = -4(0.19 - r)$$ as

$$r = \frac{\gamma + 0.76}{5}.$$

If $\gamma = 0.62$, then $r = 0.276.$

If $\gamma = -0.62$, then $r = 0.028$, as the author states.

So I don't see how the author can conclude $\gamma = -0.62$ when letting $\gamma = 0.62$ does not contradict that $r \geq 0$.

$\endgroup$
  • $\begingroup$ $ 4*0.19 = 0.76 \neq 0.71$, and what is $\gamma$ ? $\endgroup$ – MJ73550 Nov 16 '16 at 9:36
  • $\begingroup$ You're correct. I edited the original post to reflect that. However, it still allows for $\gamma$ to be positive or negative. $\gamma$ is the instantaneous rate of return on the put option. $\endgroup$ – user2521987 Nov 16 '16 at 14:21
  • 1
    $\begingroup$ It is very odd. I would have thought the condition should have been $r<\alpha$ i.e. $r<0.19$ not $r\ge 0$. In words: "the expected excess return on the stock is positive". $\endgroup$ – noob2 Nov 16 '16 at 14:32
  • $\begingroup$ Can you provide the source of this problem? $\endgroup$ – muffin1974 Nov 25 '16 at 10:55
  • $\begingroup$ Sure, it's from "Financial Economics" by Abraham Weishaus (It's a study manual for the actuarial exam "Models for Financial Economics") $\endgroup$ – user2521987 Nov 25 '16 at 16:16

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.