FBE559.slides.07

The analog of 1 e rt vs 1 r t option on a currency

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Unformatted text preview: α)S0 u + (1 − q )(1 + α)S0 d ) 1+r Which we could write as 1+α S0 = (qS0 u + (1 − q )S0 d ) 1+r This is our old equation but with B (1 + α) instead of B Old formula works with B (1 + α) replacing B : q= 1 B (1+α) −d u−d Note: Hull also uses ”continous compounded dividend yield”. The analog of: 1 e −rt vs (1 + r )t Option on a currency Suppose that the current exchange rate is 1.6 USD/GBP. Next year, the rate will either go up to 1.7 or down to 1.5. How much would it cost to buy a call option on GBP struck at 1.6 USD/GBP? Suppose that rUS = 3% and rUK = 5%. Here instead of a stock, the underlying is a currency. If you hold the currency, you are entitled to a dividend through interest payments. Let S0 be the current exchange rate (the price of the foreign currency). Option on a currency (continued) If I spend 1.6USD to buy one unit of GBP, I will have 1.05 units of GBP at the end of the year. So my total CF at the end of the year will be 1.05 S1 where S1 is the future exchange rat...
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