Chapter 11.3, Problem 22P

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. (The factor of 100 is because many derivatives involve 100 shares.) 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 EMV be the expected gain/loss from this derivative. It is a weighted average of all the possible losses and gains, weighted by their likelihoods. (Of course, any loss should be expressed as a negative number. For example, a loss of $1500 should be expressed as -$1500.) Unfortunately, this is a difficult probability calculation, but EMV can be estimated by an @RISK simulation. Perform this simulation with at least 1000 iterations. What is your best estimate of EMV?