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,


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