Which interest should be used?

lame, interest, exercise, compound, 365

I think it may sound lame. When i read reading 70 on Option, in the section of Lower bounds, the present value of the exercise price is X/(1+r)^T. I wonder why they use the compound formula instead of X/(1+r*T) since T=number of expiring days/365.
Please help me with this.

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rgonzalez

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发表于 2011-7-13 13:41 | 只看该作者

I haven't seen (1+r*T) used anywhere to calculate Present Value, except for the fact that if you terminate the Taylor expansion of (1+ r)^T at the first order term you will get (1+r*T)

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shootingstar

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发表于 2011-7-13 13:41 | 只看该作者

Never be afraid to ask what you might perceive to be a stupid question. You have no idea how such queries can correct important misconceptions in the minds of fellow forum visitors.

In response to your question, when discounting most cash flows, we use (1+ r) ^T.

Only when you are working with LIBOR do you apply (1+r*T) to discount a cash flow.

In determining the bounds for options, the interest rate used to discount the exercise price is the risk-free rate. Therefore we use (1+r) ^T.

LIBOR is used as the interest rate to determine the present value of the interest savings in calculating the payoff on a forward rate agreement (FRA). In this case, we use (1+r*T)

Hope this helps.

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MonkeyBusiness

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发表于 2011-7-13 13:41 | 只看该作者

Dear beatthecfa

Thank for your kindly reply, i am very appreciated. So it is the matter of convention.

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