Fill This Form To Receive Instant Help
Homework answers / question archive / Prove that paying the fair price for an option always results in expected value of $0
Prove that paying the fair price for an option always results in expected value of $0.
In other words, prove that if E(A)=$x, then E(Pay $x for A)=$0.
Lets assume that with probability P(x) you win $x.
Assume with probability P(y) you win $y.
Let $H = Expected Value of this game = P(x)x + P(y)y
Consider that the fair price of this game is exactly equal to its expected value.
Hence, you pay $H every time you play the game.
Now, the expected value of the game is given as:
P(x)[x - H] + P(y)[y - H]
P(x)x - P(x)H + P(y)y - P(y)H
P(y) = 1 - P(x)
P(x)x - P(x)H + [1 - P(x)]y - [1 - P(x)]H
P(x)x - P(x)H + y - P(x)y - H + P(x)H
P(x)x + y - P(x)y - H
P(x)x + y - [1 - P(y)]y - H
P(x)x + y - y + P(y)y - H
P(x)x + P(y)y - H = Expected value of game - Fair Price
H - H
= $0