The risk-free rate is 5% and the expected return on a non-dividend-paying stock is 12%. Which of the following is a way of valuing a derivative?
A. Assume that the expected growth rate for the stock price is 17% and discount the expected payoff at 12%
B. Assuming that the expected growth rate for the stock price is 5% and discounting the expected payoff at 12%
C. Assuming that the expected growth rate for the stock price is 5% and discounting the expected payoff at 5%
D. Assuming that the expected growth rate for the stock price is 12% and discounting the expected payoff at 5%
C
Risk-neutral valuation shows that a derivative can be correctly valued by assuming that the stock grows at the risk-free rate and discounting the expected payoff at the risk-free rate. It follows that C is the correct answer.
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