Explanation:
The yield measure on exotic options on currencies is incorrect. In the valuation of exotic options on currencies, the yield is set equal to the foreign risk-free rate, not the domestic risk-free rate. This is because the yield on the underlying asset, in this case, the currency, is influenced by the interest rates in the foreign country. The foreign risk-free rate is the rate of return of a hypothetical investment with no risk of financial loss, over a given period, in the foreign country. Therefore, it is the foreign risk-free rate that should be used in the valuation of exotic options on currencies, not the domestic risk-free rate.
Choice A is incorrect. The yield measure on exotic options on stock indices is correctly stated. When valuing exotic options on stock indices, the yield is typically set equal to the dividend yield on the index. This reflects the fact that holders of such options are effectively exposed to the dividends paid by the companies in the index.
Q.785 In the valuation of exotic options, the yield on the underlying asset must be taken into considerations. The yield on the underlying assets is present in different forms and variables for different options. For instance:
I. In the valuation of exotic options on stock indices, the yield is set equal to the dividend yield on the index
II. In the valuation of exotic options on currencies, the yield is set equal to the domestic risk-free rate
III. In the valuation of exotic options on futures, if the domestic currency is the base currency, then the yield would be the domestic risk-free rate
Which of these yield measures is incorrect?
A
The yield measure on exotic options on stock indices is incorrect.
B
The yield measure on exotic options on currencies is incorrect.
C
The yield measure on exotic options on futures is incorrect.
D
None of the exotic options have incorrect yield measures.
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