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Spot Rates Risk-Free Rates

S0($/€) $1.60 = €1.00 i$ 3.00%


S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%
Calculate the current €/£ spot exchange rate.

(€1.25/£1.00)=(€1.00/$1.60)X($2.00/£1.00)
Consider an option to buy £10,000 for €12,500. In the next period, if the pound
appreciates against the dollar by 37.5 percent then the euro will appreciate against
the dollar by ten percent. On the other hand, the euro could depreciate against the
pound by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.
Spot Rates Risk-free Rates
S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

State the composition of the replicating portfolio; your answer should contain "trading
orders" of what to buy and what to sell at time zero.

Buy the present value of 5/9 × £10,000 partly financed by borrowing the pv of 5/9 × €10,000

Consider an option to buy €12,500 for £10,000. In the next period, the euro can
strengthen against the pound by 25 percent (i.e., each euro will buy 25 percent more
pounds) or weaken by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-Free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

Calculate the hedge ratio.


H=(£2,500−€0)/(£12,500−€8,000)=5/9

Find the dollar value today of a 1-period at-the-money call option on ¥300,000. The spot
exchange rate is ¥100 = $1.00. In the next period, the yen can increase in dollar value by 15
percent or decrease by 15 percent. The risk-free rate in dollars is i$ = 5%; The risk-free rate
in yen is i¥ = 1%.

TO FIND THE RISK NEUTRAL PROBABILITY, EQUATE THE VALUE OF ¥300,000 AT


THE IRP FORWARD RATE TO THE EXPECTED VALUE PX$34,500+(1-P)X$2,550
P=($3,118.81-$2,550)/($3,450-$2,550)=0.6320
¥300,000X($1.00/¥100)=$3,000
Co=$270.86
$270.86=(0.6320X$450)/1.05

Consider an option to buy £10,000 for €12,500. In the next period, if the pound
appreciates against the dollar by 37.5 percent then the euro will appreciate against
the dollar by ten percent. On the other hand, the euro could depreciate against the
pound by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

Use your results from the last three questions to verify your earlier result for the
value of the call.
C0=(4/9 × €3,125)/1.04=€1,335.47=€6,677.35 − €5,341.88
The value of our option is correct, computed both with risk neutral valuation and with the
replicating portfolio.

Consider an option to buy €12,500 for £10,000. In the next period, the euro can
strengthen against the pound by 25 percent (i.e., each euro will buy 25 percent more
pounds) or weaken by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-Free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

If the call finishes in-the-money what is your portfolio cash flow?

Sell the 5/9 × €12,500 at the exchange rate of €1/£1, receive


£6,944.44 = (5/9 × €12,500) × £1/€1.00
Repay the banker £4,444.44
portfolio cash flow = £2,500
Consider an option to buy €12,500 for £10,000. In the next period, the euro can
strengthen against the pound by 25 percent (i.e., each euro will buy 25 percent more
pounds) or weaken by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-Free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

If the call finishes out-of-the-money what is your portfolio cash flow?


Sell the 5/9 × €12,500 at the exchange rate of €1/£1.5625, receive
£4,444.44 = (5/9 × €12,500) × £1/€1.5625
Repay the banker £4,444.44
Portfolio cash flow = £0

Consider an option to buy €12,500 for £10,000. In the next period, the euro can
strengthen against the pound by 25 percent (i.e., each euro will buy 25 percent more
pounds) or weaken by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-Free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

Find the cost today of your hedge portfolio in pounds


£1,068.38=[(5/9 × €12,500)/1.04]×(£1/€1.25)−[(5/9 × £8,000)/1.04]
Consider an option to buy £10,000 for €12,500. In the next period, if the pound
appreciates against the dollar by 37.5 percent then the euro will appreciate against
the dollar by ten percent. On the other hand, the euro could depreciate against the
pound by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

Calculate the hedge ratio.


H=[(€3,125−€0)/€15,625]−€10,000=5/9
Consider an option to buy €12,500 for £10,000. In the next period, the euro can
strengthen against the pound by 25 percent (i.e., each euro will buy 25 percent more
pounds) or weaken by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-Free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

State the composition of the replicating portfolio; your answer should contain "trading
orders" of what to buy and what to sell at time zero.
Buy the present value of 5/9 × €12,500 at the spot rate of £1 = €1.25
Borrow the present value of 5/9 × £8,000

Consider an option to buy £10,000 for €12,500. In the next period, if the pound
appreciates against the dollar by 37.5 percent then the euro will appreciate against
the dollar by ten percent. On the other hand, the euro could depreciate against the
pound by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

Find the risk neutral probability of an "up" move.


a=(€12,500−€10,000)/(€15,625−€10,000)=4/9
Consider an option to buy €12,500 for £10,000. In the next period, the euro can
strengthen against the pound by 25 percent (i.e., each euro will buy 25 percent more
pounds) or weaken by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-Free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

Find the risk neutral probability of an "up" move.


a=(£10,000−£8,000)/(£12,500−£8,000)=4/9
Consider an option to buy £10,000 for €12,500. In the next period, if the pound
appreciates against the dollar by 37.5 percent then the euro will appreciate against
the dollar by ten percent. On the other hand, the euro could depreciate against the
pound by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

If the call finishes out-of-the-money what is your replicating portfolio cash flow?
We own 5/9 × £10,000 at the exchange rate of €1/£1 that is worth
€5,555,56 = £5,555.56 × €1/£1
We also owe €5,555,56 to our banker, so the portfolio cash flow = €0

Consider an option to buy £10,000 for €12,500. In the next period, if the pound
appreciates against the dollar by 37.5 percent then the euro will appreciate against
the dollar by ten percent. On the other hand, the euro could depreciate against the
pound by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

If the call finishes in-the-money what is your replicating portfolio cash flow?
We own 5/9 × £10,000 at the exchange rate of €1.5625/£1 that is worth
€8,680.56 = £5,555.56 × €1.5625/£1
We also owe €5,555,56 to our banker, so the portfolio cash flow = €3,125

Consider an option to buy €12,500 for £10,000. In the next period, the euro can
strengthen against the pound by 25 percent (i.e., each euro will buy 25 percent more
pounds) or weaken by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-Free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

Use your results from the last three questions to verify your earlier result for the
value of the call.
C0=(4/9 × £2,500)/1.04=£1,068.38
£1,068.38=[5/9 × (€12,500/1.04)]×(£1/€1.25)−[5/9 × (£8,000
/1.040)
The value of our option is correct, computed both with rise neutral valuation and with the
replicating portfolio.
Consider an option to buy £10,000 for €12,500. In the next period, if the pound
appreciates against the dollar by 37.5 percent then the euro will appreciate against
the dollar by ten percent. On the other hand, the euro could depreciate against the
pound by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

Find the value today of your replicating today’s portfolio in euro.


€1,335.47 = €6,677.35 – €5,341.88
where the cost of the euro is
€6,677.35 = [(5/9 × £10,000)/1.04]×(€1.25£1/€6,677.35) ×(€1.25/£1)
less the borrowing inflow
€5,341.88=(5/9 × €10,000)/1.04
Consider an option to buy €12,500 for £10,000. In the next period, the euro can
strengthen against the pound by 25 percent (i.e., each euro will buy 25 percent more
pounds) or weaken by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-Free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

USING RISK NEUTRAL VALUATION, find the value of the call (in pounds)

C0=(4/9 × £2,500)/1.04=£1,068.38
Consider an option to buy £10,000 for €12,500. In the next period, if the pound
appreciates against the dollar by 37.5 percent then the euro will appreciate against
the dollar by ten percent. On the other hand, the euro could depreciate against the
pound by 20 percent.
Big hint: don't round, keep exchange rates out to at least 4 decimal places.

Spot Rates Risk-free Rates


S0($/€) $1.60 = €1.00 i$ 3.00%
S0($/£) $2.00 = £1.00 i€ 4.00%
S0(€/£) €1.25 = £1.00 i£ 4.00%

USING RISK NEUTRAL VALUATION (i.e., the binomial option pricing model) find
the value of the call (in euro).
C0=(4/9 × €3,125)/1.04=€1,335.47

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