I didn’t get an example explained in Probability in Finance lecture.I guess it is somewhere wrong.Could u plzz explain.
Thanks for reaching out!
Generally, you might not be getting the concept since finance includes all these fancy words that make it sound more complicated than it actually is. Now, imagine you go to the farmers’ market today and you see that John is selling fantastic tomatoes at $2.50 per pound. However, you bought tomatoes just yesterday, so you don’t need to buy any today. However, you’ll probably need to buy some next week, so you bargain with John and pay him $3 now for the right to buy tomatoes from him next week at $2.50. It’s important it’s a right to buy, rather than an obligation to buy, so it’s up to us to decide whether we want to take advantage next week.
Next week comes around and we see that John is selling his tomatoes at $2.25 per pound. Even though we struck a deal with him last week, it’s more sensible not to take advantage of the deal and just buy his tomatoes at the market price – $2.25.
Alternatively, we can go to the market and see that since there’s fewer tomato farmers at the market today, John’s jacked up his prices to $3 per pound. Then, you exercise the option you paid for and purchase tomatoes off of him at the predetermined price of $2.50, rather than the market price of $3.
The $3 we pay John are the premium. Essentially, $3 is what we paid for the right of paying $2.50 per pound if we wish to do so. Pretty much the same happens with in the finance example we’re showing you, but the premium is $100 and the prices are not per pound, but per share.
As for the homework, we have two ways of calculating the premium. The first one is to assume premium equals c, then find the expected payoff of the deal and set it equal to $0. After solving for c, we’ll know what the premium for a fair deal is. Alternatively, if we assume the premium is $0, then the expected payoff would give us the price of appropriate price for the premium. Essentially, for this deal to be fair, we’re paying as much as we expect to make on average out of this deal.
Hope this helps!
I understand the concept but can you explain how the values were calculated in the example please? I am not sure if $1100 was an arbitrary value chosen and unsure of how to utilize the calculations on the following problems. Thanks
The $1,100 pricetag was taken from the actual value of Google Stocks when we were initially writing the scrips for the video (which was in the fall/winter of 2018). You can follow this Yahoo Finance link if you want to fact-check this: https://finance.yahoo.com/quote/GOOG?p=GOOG&.tsrc=fin-srch
As for the following problems, the $1,100 is the price today. If we have a problem where we’re trying to estimate whether something is a fair deal or not, we use whatever we’re given as the current price instead of $1,100.