Week 7-8: Tutorial Problem Set 7

(Solution Guide ) *

April 14, 2022

Topic: Currency Options

In all the following problems: (i) the underlying currencies to be bought and
sold are currencies other than the Australian dollar; (ii) the exchange rates
are expressed as units of the Australian dollar per one unit of the underlying
currency; and (iii) prot and loss are measured in terms of the Australian dollar.
1. A call option allows the holder to buy EU R 100, 000 against the Australian
dollar at an exercise exchange rate of 1.6500 (AU D/EU R). Determine
whether or not the holder will exercise the option, and then calculate the
gross payo at the following spot exchange rates:
(a) 1.6630;
Solution: The gross payo for call option from the holder's per-
spective is given by: (S − E, 0)+ = max (S − E, 0), where S = spot
exchange rate and E = exercise exchange rate. Since S = 1.6630 >
1.6500 = E,the holder will exercise the call option. The holder will
buy at 1.65 and sell on the spot market at 1.6630. The gross payo
realized is:
ΠGross = EU R100000 × (1.6630 − 1.6500) AU D/EU R = 1300AU D.
(b) 1.6500;

Solution: Since S = 1.6500 = 1.6500 = E,the holder is indier-

ent . In any case, the holder of the option will incur loss up to
the amount of the premium. However, suppose if S = 1.69,then
the holder will exercise the option, i.e. buy euro at 1.65 and sell
on the spot market at 1.69. The gross payo realized is: ΠGross =
EU R100000 × (1.6900 − 1.6500) AU D/EU R = 4000AU D.
* Prepared by: Course Coordinator Dr. Ronald R. Kumar - Semester 1, 2022-FM303,
School of Accounting, Finance and Economics, The University of the South Pacic, Laucala
Campus, Suva, Fiji

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

and
(c) 1.6380.
Solution: If S = 1.6380 < 1.6500 = E,then the holder will not
exercise the option, i.e. buy euro at 1.65 and sell on the spot market
at 1.69. In any case, the holder of the option will incur loss up to the
amount of the premium.
2. A put option allows the holder to sell CHF 200, 000 at an exercise ex-
change rate of 1.1360 (AU D/CHF ). Determine whether or not the holder
will exercise the option, and then calculate the gross payo at the following
spot exchange rates:
(a) 1.1420;
Solution: The gross payo for put option from the holder's per-
spective is given by: (E − S, 0)+ = max (E − S, 0), where S = spot
exchange rate and E = exercise exchange rate. Since S = 1.1420 >
1.1360 = E,the holder will not exercise the put option. n any case,
the holder of the option will incur loss up to the amount of the pre-
mium.

(b) 1.5100;
Solution: Since S = 1.5100 > 1.1360 = E,the holder will not exer-
cise the put option. the holder will not exercise the put option. In
any case, the holder of the option will incur loss up to the amount of
the premium.
(c) 1.1240.
Solution: Since S = 1.1250 < 1.1360 = E,the holder will exercise
the put option. The gross payo realized is: ΠGross = CHF 200000 ×
(1.1360 − 1.1250) AU D/CHF = 2400AU D.
3. A call option allows the holder to buy U SD 100, 000 at an exercise ex-
change rate of 1.8000 (AU D/U SD). If the premium paid is 0.5 Australian
cents for each U SD, calculate the net payo at the following spot exchange
rates:
(a) 1.8040;
Solution: Here, we are given the price of call, c = 0.005AU D per
unit of underlying currency (U SD) traded, and we have call op-
htion from the iholder's perspective. So the net payo is: Πnet =
(S − E) − c × unit of underlying currency. Since S = 1.8040 >
+

E = 1.800, then the call option is exercised and the net payo
is: Πnet = [(1.8040 − 1.800) − 0.005AU D/U SD] × U SD100, 000 =
−100AU D (here the holder makes a loss, but not exercising will re-
sult in even higher loss of 100, 000 × 0.005 = −500AU D

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

(b) 1.8260;
Solution: Since S = 1.8260 > E = 1.800, then the call option is ex-
ercised and the net payo is: Πnet = [(1.8260 − 1.800) − 0.005AU D/U SD]×
U SD100, 000 = 2100AU D
(c) 1.7870.
Solution: Since S = 1.7870 < E = 1.800, then the call option is not
exercised and the net payo is: Πnet = [(0) − 0.005AU D/U SD] ×
U SD100, 000 = −500AU D

(d) At whath exchange ratei will the holderhbreak even? i

Πnet = (S − E) − c = 0 ⇒ Πnet = (S − 1.800) − 0.005 = 0 ⇒
+ +

S − 1.805 ⇒ S = 1.805AU D.
4. A put option allows the holder to sell N OK 250, 000 at an exercise ex-
change rate of 0.190 (AU D/N OK ). If the premium paid is 0.4 Australian
cents for each N OK , calculate the net payo at the following spot ex-
change rates:
(a) 0.200;
Solution: Here, we are given the price of put, p = 0.004AU D per
unit of underlying currency (N OK ) traded, and we have put op-
tion
h from the iholder's perspective. So the net payo is: Πnet =
(E − S) − p × unit of underlying currency. Since S = 0.20 >
+

E = 0.190, then the put option is not exercised and the net payo
is: Πnet = [0 − 0.004AU D/N OK] × N OK250, 000 = −1000AU D
(b) 0.192;
Solution: So the net payo is: Πnet = (E − S)+ − p ×unit of underlying currency.
h i

Since S = 0.192 > E = 0.190, then the put option is not exercised
and the net payo is: Πnet = [0 − 0.004AU D/N OK]×N OK250, 000 =
−1000AU D

and
(c) 0.180.
Solution: So the net payo is: Πnet =
h i
(E − S) − p ×unit of underlying currency.
+

Since S = 0.180 < E = 0.190, then the put option is exercised

and the net payo is: Πnet = [(0.19 − 0.18) − 0.004AU D/N OK] ×
N OK250, 000 = 1500AU D

(d) At whath exchange ratei will the holder break even?

Πnet = (E − S) − p = 0 ⇒ Πnet = [(0.19 − S) − 0.004AU D/N OK] =
+

0 ⇒ 0.186AU D/N OK − S = 0 ⇒ S = 0.186(AU D/N OK)

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

5. The following information is available at the end of December:

Spot exchange rate (AU D/U SD) 1.9640
Three month forward rate 1.9850
Price of a call option expiring at the end of March AU D0.01
Price of a put option expiring at the end of March AU D0.01
Exercise exchange rate for the call option 1.9750
Exercise exchange rate for the put option 2.0050
A forecaster has produced the following values for the AU D/U SD ex-
change rate prevailing at the end of March:
• 1.9800 with a probability of 0.6, and
• 1.9620 with a probability of 0.4.
(a) What will you do if you act on the basis of the higher forecast?
Solution: Here are strategies, and we select the one the protable
strategy:
i. The 3-month higher forecast is 1.9800 with probability of 0.6. If
S = 1.9800 (the higher forecast), then the underlying currency
(U SD) can be sold at the three-month forward rate F = 1.9850
and bought on the spot at S = 1.9800,realizing a per unit gross
prot of: F − S = 1.9850 − 1.9800 = 0.005AU D (assuming we
have the counterparty to make the transaction, and there is no
other cost associated with the contract). Here, you are writing
a forward contract.
ii. Write a 3-month call option at c = 0.01AU D,to sell the under-
lying currency (U SD) at E = 1.9750, and sell on spot at 1.9800.
In 3-months, S = 1.9800 > E = 1.9750, so the holder will ex-
ercise the option. The net prot per unit for the writer is :
Πnet = (1.9750 − 1.9800) + 0.01 = 0.005AU D. Here, your prot
is coming from primarily trading in options.
iii. Buy a 3-month put option at p = 0.01AU D, to sell the under-
lying currency (U SD) at E = 2.0050, and buy on spot at 1.9800.
The net prot per unit for the holder is: Πnet = (2.0050 − 1.9800)−
0.01 = 0.015AU D
We can see that options (i), (ii) and (iv) has the positive returns,
and hence are protable strategies. If we are to act on the high-
est gains, then (iii) will be selected. Strategies (i) and (ii) gives
same prots, but (ii) may be preferred over (i) because of the
counterparty risk.
(b) What will you do if you act on the basis of the lower forecast?
Solution: Here are strategies, and we select the one the protable
strategy:
i. The 3-month lower forecast is 1.9620 with probability of 0.4. If
S = 1.9620 (the lower forecast), then the underlying currency
(U SD) can be sold at the three-month forward rate F = 1.9850
and bought on the spot at S = 1.9620,realizing a per unit gross

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Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

prot of: F − S = 1.9850 − 1.9620 = 0.023AU D (assuming we

have the counterparty to make the transaction, and there is no
other cost associated with the contract). Here, you are writing
a forward contract.
ii. Write a 3-month call option at c = 0.01AU D,to sell the underly-
ing currency (U SD) at E = 1.9750, and buy on spot at 1.9620.
Since S = 1.9620 < 1.9750 = E , the option will not be exercised.
The net prot per unit to the writer is: Πnet = (0) + 0.01 =
0.01AU D. This is a protable strategy, where gain will come
primarily from option trading.
iii. Buy a 3-month put option at p = 0.01AU D, to sell the under-
lying currency (U SD) at E = 2.0050, and buy on spot at 1.9620.
The net prot per unit for the holder is: Πnet = (2.0050 − 1.9620)−
0.01 = 0.033AU D
We can see that options (i), (iii) and (iv) has positive returns,
and hence are protable strategies. If we are to act on the highest
gains, then (iii) will be selected. Between (i) and (ii), (i) may be
preferred assuming no counterparty risk, however (ii) eliminates
the risk.
(c) What will you do if you act on the basis of the expected value of the
forecast?
Solution: Here are strategies, and we select the one the protable
strategy. Ŝ = 0.6 × 1.9800 + 0.4 × 1.9620 = 1.9728:
i. The 3-month expected forecast is S = 1.9728. If S = 1.9728 (the
expected forecast), then the underlying currency (U SD) can be
sold at the three-month forward rate F = 1.9850 and bought
on the spot at S = 1.9728,realizing a per unit gross prot of:
F − S = 1.9850 − 1.9728 = 0.0122AU D (assuming we have the
counterparty to make the transaction, and there is no other cost
associated with the contract). Here, you are writing a forward
contract.
ii. Write a 3-month call option at c = 0.01AU D,to sell the underly-
ing currency (U SD) at E = 1.9750, and buy on spot at 1.9620.
Since S = 1.9728 < 1.9750 = E , the option will not be exercised.
The net prot per unit to the writer is: Πnet = (0) + 0.01 =
0.01AU D. This is a protable strategy, where gain will come
primarily from option trading.
iii. Buy a 3-month put option at p = 0.01AU D, to sell the un-
derlying currency (U SD) at E = 2.0050, and buy on spot at
S = 1.9728. The net prot per unit for the holder is: Πnet =
(2.0050 − 1.9728) − 0.01 = 0.0222AU D
We can see that options (i), (iii) and (iv) has positive returns,
and hence are protable strategies. If we are to act on the highest
gains, then (iii) will be selected. Between (i) and (ii), (i) may be

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

preferred assuming no counterparty risk, however (ii) eliminates

the risk.
6. The following information is available:
Call contract size GBP 200, 000
Put contract size GBP 200, 000
Price of call AU D0.01
Price of put AU D0.008
Exercise exchange rate of call 2.50
Exercise exchange rate of put 2.50
Calculate the net pay-o on long call, long put and the combined position
at the following spot exchange rates:
(a) 2.505;
(b) 2.540;
(c) 2.495; and
(d) 2.480.
Solution:

Question # Spot rate

(AUD/USD)
Long Call
(AUD)
Long Put
(AUD)
Net Combined
(AUD)
(a) 2.505 −1000 −1600 −2600 (loss)
(b) 2.540 6000 −1600 4400
(c) 2.495 −2000 −600 −2600 (loss)
(d) 2.480 −2000 240 400
*Refer to Problem Set 7 Excel Sheet
7. The following information is available:
Call contract size CAD400, 000
Put contract size CAD400, 000
Price of call AU D0.01
Price of put AU D0.01
Exercise exchange rate of call 0.96
Exercise exchange rate of put 0.94
Calculate the net pay-o on short call, short put and the combined posi-
tion at the following spot exchange rates:
(a) 0.99;
(b) 0.97;
(c) 0.95; and
(d) 0.93.
Solution:

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

Question # Spot rate LongCall LongPut Net combined

(AUD/CAD) (AUD) (AUD) (AUD)
(a) 0.990 −8000 4000 −4000 (loss)
(b) 0.970 0 4000 4000 (prot)
(c) 0.950 4000 4000 8000 (prot)
(d) 0.930 4000 0 4000 (prot)
*Refer to Problem Set 7 Excel Sheet
8. Use the information given in problem 6 to calculate the intrinsic values
of the two options at various values of the exchange rate
Solution: Hence, the intrinsic value of the option is positive when the
option is in the money, and 0 otherwise.
• The intrinsic value of a call option is the dierence between the spot
exchange rate and the exercise exchange rate if the dierence is positive
and zero otherwise, that is, (S − E)+ .
• The intrinsic value of a put option is the dierence between the exercise
exchange rate and the spot exchange rate if the dierence is positive and
zero otherwise, that is, that is: (E − S)+
*Refer to Problem Set 7 Excel
9. Use the information given in problem 7 to calculate the intrinsic values
of the two options at various values of the exchange rate
*Refer to Problem Set 7 Excel