[R-SIG-Finance] Newbie question on risk free Interest Rate

[Mahesh Krishnan]

The answer to your problem lies in understanding the replicating portfolio for the instrument you are trying to price.

In the case of a bond, you can reproduce the payoffs by reinvesting proceeds of a short tenor bill into the forward term structure. Hence, the discount rate must be the same as the tenor of the bond.

In the case of an option, replication is done by continuously rebalancing a stock-money market portfolio. So, the interest rate you need is the short rate, example the overnight repo rate.

Mahesh.


Sent via BlackBerry

-----Original Message-----
From: "bogaso.christofer" <bogaso.christofer at gmail.com>

Date: Mon, 29 Dec 2008 03:23:25 
To: <r-sig-finance at stat.math.ethz.ch>
Subject: [R-SIG-Finance] Newbie question on risk free Interest Rate


Hi,

 

I would like to ask one newbie question on risk free interest rate. This is
the essential part to price any financial derivatives, like options,
Interest Rate only [IO] strip etc. My question is standing at time "t" which
risk free interest rate I should consider? 3 month, 6 month, 10 year t-bill
or t-bond ? for example suppose, I need to price a call option using BS
formula, whose remaining life time is 2 years and another option whose life
time is 5 months. Which interest rate I need to take to value those 2
options? After some goggling it is suggested to take 3 month t-bill as risk
free rate. What is the logic behind that?

 

Again suppose, an Investor is to purchase an IO strip for 7 years, on a 10
years mortgage. In this case, I saw one book [by Cuthbertson], suggested to
take annual yield on 10-year t-bond to calculate NPV of all future Interest
payment against mortgage. However again it did not say why to take 10-year
bond not, 3-month t-bill.

 

Can anyone here please clarify me on above doubts? Your help will be highly
appreciated.

 

Thanks and regards,


	[[alternative HTML version deleted]]

_______________________________________________
R-SIG-Finance at stat.math.ethz.ch mailing list
https://stat.ethz.ch/mailman/listinfo/r-sig-finance
-- Subscriber-posting only.
-- If you want to post, subscribe first.