Question

In the financial world, there are many types of complex instruments called derivatives that derive their value from the value of an underlying asset. Consider the following simple derivative. A stock’s current price is $80 per share. You purchase a derivative whose value to you becomes known a month from now. Specifically, let P be the price of the stock in a month. If P is between $75 and $85, the derivative is worth nothing to you. If P is less than $75, the derivative results in a loss of 100*(75–P) dollars to you. If P is greater than $85, the derivative results in a gain of 100*(P–85) dollars to you. Assume that the distribution of the change in the stock price from now to a month from now is normally distributed with mean $1 and standard deviation $8. Let P(big loss) be the probability that you lose at least $1000 (that is, the price falls below $65), and let P(big gain) be the probability that you gain at least $1000 (that is, the price rises above $95). Find these two probabilities. How do they compare to one another?



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  • CreatedApril 01, 2015
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