Chartered Financial Analyst (CFA) Practice Exam Level 2

In the context of a risky asset's value, what does the formula V Risky = Vrf - Vput signify?

1. The net value of a risky asset compared to a risk-free asset plus a put option

2. The relationship of equity value to debt obligations

3. The total liabilities of a risky investment

4. The calculation of equity option pricing

The correct answer is: The net value of a risky asset compared to a risk-free asset plus a put option

The formula V Risky = Vrf - Vput represents the concept of valuing a risky asset by incorporating the value of risk-free assets and the protection provided by a put option. Here, V Risky denotes the value of the risky asset, Vrf represents the value of a risk-free asset, and Vput signifies the value of the put option associated with that risky asset. This formulation suggests that the value of a risky asset can be understood as the risk-free value minus the value of having the put option, which serves to limit potential losses. The put option provides a form of insurance against declines in the asset's value, hence its subtraction from the risk-free value reflects the risk premium associated with the asset. The correct choice highlights the interaction between the inherent risk of the asset and the risk mitigation provided by the put option, creating a useful model for understanding asset valuation in the face of uncertainty. The other options focus on different concepts, such as equity and debt relationships, total liabilities, and equity option pricing, which do not align with the specific valuation context provided by this formula.