In: Finance
At writing, 1 Euro is equivalent to 0.89 GBP (i.e., British
pounds). Assume that the
interest rate over one (annual) timestep in Britain is rGB = 1:5%,
and in Europe, it
is rE = 2:0%. Operate in CRR notation with u = 1:15, and d = 1=u
throughout this
question, and specify which currency you are using in all
answers.
Assume that your domestic currency is GBP.
(i) Calculate the risk neutral probability for an exchange rate
option. Let each
time step represent one year, so you can use the interest rates
given without
conversion.
(ii) Assume the strike rate of an exchange rate (European) call
option is k = 1:00
GBP/EUR, and the face value is F = EUR10; 000. Construct a
binomial
tree and calculate the premium of this call option, in GBP.
(iii) Using the same strike rate and face value, calculate the
premium of an ex-
change rate European put (in GBP).