from Adam:

"I am writing this, not as an expert in R, but as someone who traded options
on the floor of the CME for years. My comment is relevant to pricing options
on a U.S. exchange where one can borrow cash from the clearing firm to buy
options as long as the value of the account will support the risk margin.
Similarly one is paid interest on the short value of options that are
sold.   Firstly as someone has mentioned, the interest rate one uses is
essentially irrelevant unless one is dealing with very long dated options or
one is dealing with deep in the money options. I would generally leave the
interest rate alone until rates had moved close to 200 basis points, and
then there was no rush. Changes in interest rates had little effect on atm
prices.   When  I was either borrowing or lending a lot of money, usually
due to being long or short quantities of in the money options,  I used rates
relevant to my actual costs- which were typically tied (on U.S. exchanges!)
to 30 day T-bill rates.  I don't know if that is true at the moment.  If the
risk free rate is below .5% and you need to pay 2% to borrow cash to buy
options, you had better use 2% or as a practical matter you will find
oneself long all deep in the money options as everyone else borrows from you
at 1.5% better than their clearing firms will do.  In conclusion, for a
theoretical analysis pretty much any rate will do, but for actual pricing to
trade, better find out what money costs to borrow and lend.

Adam Ginensky"

2009/6/2 Stanley Neo <stanley.neo@gmail.com>

>  personally, I use the rates that is for the particular maturity. eg if
> its a 2.5month EUR call USD put, do an interpolation (cubic or linear - its
> your preference) on the 1 and 3 month EUR and USD rates. typically i will
> use the interbank rates for short end and the swaps for the long end.
>
> having said that, the real impact of short dated (<1yr) options (and
> therefore short dated rates) are pretty low. the issue only arise if you are
> concerned with long dated options.
>
> the most liquid and developed option markets are the spot forex markets.
> you may want to consult an fx option market maker for real world practice.
>
>
>
>>
>>
>> On Jun 1, 2009, Bogaso <bogaso.christofer@gmail.com> wrote:
>>
>> any view pls?
>>
>>
>> Bogaso wrote:
>> >
>> > Hi, I have come across one more question. I understood that for BS
>> options
>> > pricing, I should take short rate i.e. overnight rate because BS derive
>> > option price through some replicating portfolio which is changed
>> > instantaneously. However if I price an instrument using Black formula,
>> > wherein only the distribution of underlying at maturity period is
>> > considered
>> > i.e. in this case there is no replicating portfolio story, shouldn't I
>> > consider risk free rate for longer horizon i.e. a rate whose maturity
>> > period
>> > exactly matches with the life of the instrument?
>> >
>> > I mean to say, under Black's framework, one only needs to calculate
>> > expected
>> > value of the instrument like E[max(0, S[T] - K)] at maturity and then to
>> > calculate the present value of that. In this case there is nothing abt
>> > replicating portfolio. Therefore I feel that to calculate PV I should
>> > consider LIBOR with maturity [o, T].
>> >
>> > What you feel on that? If I am correct i.e. if I price same option using
>> > BS
>> > and Black, there must be some fundamental difference in theoretical
>> option
>> > price.
>> >
>> > -----Original Message-----
>> > From: glenn [mailto:g1enn.roberts@btinternet.com]
>> > Sent: 29 December 2008 17:33
>> > To: bogaso.christofer
>> > Subject: Re: [R-SIG-Finance] Newbie question on risk free Interest Rate
>> >
>> > Further to Mahesh's answer Christofer, think of it like this;
>> >
>> > The rate in the BS calculation represents a rate that any portfolio
>> > consisting of an option and the delta equivalent of the underlying (in
>> > your
>> > example a swap maybe) MUST earn. Think about how long the portfolio will
>> > remain delta neutral (risk free) for before a re-balence is needed.
>> That's
>> > the rate you want i.e the short rate.
>> >
>> > Glenn
>> >
>> >
>> > On 28/12/2008 21:53, "bogaso.christofer" <bogaso.christofer@gmail.com>
>> > wrote:
>> >
>> >> 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,
>> >>
>> >>
>> >> [[alternative HTML version deleted]]
>> >>
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>> View this message in context:
>>
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>>
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>>
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-- 
-- 
regards,
Stanley, Neo Horng-Yueh
Mobile: (65) 9387 7690
Email: stanley.neo@gmail.com

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