Financial Risk Manager Part 2
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The risk committee of company ABC's board is currently analyzing the variance in the pricing of deep out-of-the-money call options on both ABC's stock and the USD/GBP foreign exchange rate. They are utilizing the Black-Scholes-Merton model to facilitate this examination. The committee is considering the valuation of these options based on two different probability distributions for the asset prices at expiration: a lognormal distribution and an implied risk-neutral distribution derived from the volatility smile, with the same maturity and moneyness for each option. What will be the accurate outcome if the implied risk-neutral distribution is used instead of the lognormal distribution?
The risk committee of company ABC's board is currently analyzing the variance in the pricing of deep out-of-the-money call options on both ABC's stock and the USD/GBP foreign exchange rate. They are utilizing the Black-Scholes-Merton model to facilitate this examination. The committee is considering the valuation of these options based on two different probability distributions for the asset prices at expiration: a lognormal distribution and an implied risk-neutral distribution derived from the volatility smile, with the same maturity and moneyness for each option. What will be the accurate outcome if the implied risk-neutral distribution is used instead of the lognormal distribution?
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A
The price of the option on ABC stock would be relatively high and the price of the option on USD/GBP FX rate would be relatively low compared to those computed from the lognormal counterparts.
18.8%
B
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