Good day,
I have a question according Expected payoff calculation.
In task we compare a reasonableness of buying stocks. We have a chance:
- 0.4 to increase a price of 1 stock to 1200$; profit = 12000 – 11000 – 100(premium) = +900$ – Result of event 1
- 0.6 to decrease a price of 1 stock to 1000$; losses = 10000 – 11000 – 100 = -1100$ – Result of event 2
When we compare a risk, we compare a profit and losses:
E(P) = 0.4*900 + (-1100)*0.6 = 360 – 660 = -260.
I can’t understand what I missed.
Hey Iurii,
Thanks for reaching out!
Okay, so the idea here is that you’ve struck a deal, where you have the option (but not the obligation) to buy the shares at the given price. Hence, if the price goes down, then we’re better off just purchasing the stocks at their market value ($1,000), rather than the price we agreed upon earlier ($1,100). Hence, in the second scenario we only have a loss of $100 (the premium), rather than $1,100 ( 10 * $100 losses on shares + $100 loss on the premium).
Hope this helps!
Best,
365 Vik