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# Fins 3616 Ch6 Essay

2331 words - 10 pages

Kirt C. Butler, Solutions for Multinational Finance, 4th edition

Chapter 6 Currency Options and Options Markets
6.1

What is the difference between a call option and a put option?
A call option is an option to buy the underlying asset at a predetermined exercise price. A put
option is an option to sell the underlying asset at the exercise price.

6.2

What are the differences between exchange-traded and over-the-counter currency options?
Exchange-traded currency options are standardized as to currencies, maturity, exercise prices, and
settlement procedures. Over-the-counter options traded by commercial and investment banks can be
tailored to ...view middle of the document...

For a call on the spot rate Sd/f, intrinsic value is
equal to max(Sd/f–Kd/f,0). For a put option, intrinsic value is equal to max(Kd/f–Sd/f,0). Time value is
the difference between the market value and the intrinsic value of an option and reflects the
additional value of waiting until expiration before exercise. Time value primarily depends on time
to expiration and volatility in the underlying exchange rate. Foreign and domestic interest rates play
a lesser role for most currency options.

6.7

In what ways can you estimate currency volatility?
Exchange rate volatility is a key determinant of currency option value because it is not directly
observable in the marketplace. The other determinants of option value (foreign and domestic
interest rates, exercise price, time to expiration, and underlying exchange rate) are usually
observable. Volatility can be estimated from historical volatilities (the recent history of exchange
rate movements) or implied volatilities (volatilities implied by the five observable determinants of
option values and the observed market price of an option).

Problem Solutions
6.1

A call option to buy pounds sterling with krone is equivalent to a put option to sell krone for pound
sterling. With pounds in the denominator, it is most convenient to think of consider the pound call.
Option values at expiration as a function of the krone value of the pound are then:
Spot rate at expiration (DKr/£)
Pound call value at expiration (DKr/£)

8.00
0.00

17

8.40
0.00

8.42
0.00

8.44
0.00

8.46
0.01

8.48
0.03

Kirt C. Butler, Solutions for Multinational Finance, 4th edition
6.2

An exercise price of DKr8.45/£ is equivalent to £0.11834/DKr. The corresponding krone put option
values are:
Spot rate at expiration (£/DKr)
Krone put value at expiration (£/DKr)

6.3

.12500 .11905 .11876 .11848 .11820 .11792
0.00
0.00
0.00
0.00
0.14
0.42

A short krone put is equivalent to a short pound call. Here are their payoff profiles.
PutT£/DKr

Call TDKr/£

£.11834/DKr

DKr8.45/£

ST£/DKr

DKr8.48/£

STDKr/£

DKr.03/£
£.11834/DKr

When the premium is included, these diagrams look like this:
PutT£/DKr

Call TDKr/£
+£.1464/DKr

+£.00204/DKr

ST£/DKr
£.11633/DKr

DKr8.45/£ DKr8.5964/£

STDKr/£

£.11834/DKr
£.11633/DKr

6.4

Buy a A\$ call and sell a A\$ put, each with an exercise price of F1\$/A\$ = \$0.75/A\$ and the same
expiration date as the forward contract. Payoffs at expiration look like this:
CallT\$/A\$

PutT\$/A\$
ST\$/A\$ +

6.5

FT\$/A\$
ST\$/A\$ =

ST\$/A\$

The arguments are the same as for call options. As the variability of end-of-period spot rates
becomes more dispersed, the probability of the spot rate closing below the exercise price increases
and put options gain value. Here are the three sets of graphs:

18

Kirt C. Butler, Solutions for Multinational Finance, 4th edition

-3

3

2

0

1

Sd/f

-1

3

2

1
...

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