Tutorial+solutions+Week+6 - Chapter 6 Currency Options and...

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Chapter 6 Currency Options and Options Markets Answers to Conceptual Questions 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 fit the needs of the client. 6.3 In what sense is a currency call option also a currency put option? Because an option to buy one currency is simultaneously an option to sell another currency, currency options are both a call (on one currency) and a put (on the other currency). 6.4 In what sense is a currency forward contract a combination of a put and a call? A currency forward contract to buy currency f at a forward price of F T d/f at time T can be replicated by purchasing a European call option on currency f with the same expiration date and an exercise price K d/f = F T d/f and simultaneously selling a put option at the same exercise price and maturity date. Conversely, a short forward contract on currency f is a combination of a written call on f and a purchased put on f with the same expiration date and exercise price. 6.5 What are the six determinants of a currency option value? The determinants of currency option values are riskless domestic and foreign interest rates, the exercise price, the underlying spot (or futures) price, the expiration date, and the volatility of the underlying exchange rate. 6.6 What determines the intrinsic value of an option? What determines time value of an option? The intrinsic value is the value if exercised today. For a call on the spot rate S d/f , intrinsic value is equal to max(S d/f –K d/f ,0). For a put option, intrinsic value is equal to max(K d/f –S d/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
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This note was uploaded on 10/29/2010 for the course FINS 3616 taught by Professor Curry during the Three '10 term at University of New South Wales.

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Tutorial+solutions+Week+6 - Chapter 6 Currency Options and...

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