Question

In the Discounted Cash Flow, the required return on a European option should be higher than the risk-free rate. Otherwise, an arbitrage exists.

(a) True

(b) False

Answer 1

TRUE. European option is the contractual right to buy or sell underlying asset on the maturity date of the contract at an agreed price called as strike price. Risk free rate is the rate given by government bonds. an investor will always expect a return over and above the normal risk free rate. That is called risk premium. the premium given for taking the risk. while making strike price, the time value of money is considered. the strike price should be set including the inflation element. If the stock is selling at a price below the risk free rate, then there is arbitrage. Arbitrage means taking advantage of price difference in two markets or over a period of time.