Chapter 11, Problem 56QA

The British pound (£) is currently worth 1.45 euros (€). This can either increase by u = 1.1 or decrease by d = 0.9 over each 4 months. Consider a European call option with a strike price of K = 1€ per £ and time-to-maturity T = 8 months. The continuously compounded risk-free rate in Britain is 4% per annum and in Europe is 10% per annum. What is the price of the European call option today? Please explain your answer using your own words and show your workings. In addition, if the option was American-style would the risk-neutral probability of an up-move be smaller than, equal to or greater than the one you have calculated? Explain why using your own words.

The British pound (£) is currently worth 1.45 euros (€). This can either increase by u = 1.1 or decrease by d = 0.9 over each 4 months. Consider a European call option with a strike price of K = 1€ per £ and time-to-maturity T = 8 months. The continuously compounded risk-free rate in Britain is 4% per annum and in Europe is 10% per annum.   What is the price of the European call option today? Please explain your answer using your own words and show your workings. In addition, if the option was American-style would the risk-neutral probability of an up-move be smaller than, equal to or greater than the one you have calculated?

Assume the spot Swiss franc is $0.7015 and the six-month forward rate is $0.6980. What is the Value of a six-month call and a put option with a strike price of $0.6815 should sell for in a rational market? Assume the annualized six-month Eurodollar rate is 3.50 percent. Assume the annualized volatility of the Swiss franc is 14.20 percent. Use the European option-pricing models to value the call and put option. This problem can be solved using the FXOPM.xls spreadsheet. (Do not round intermediate calculations. Round your answers to 2 decimal places.)