Question

Suppose an Australian importer has to make a €100,000 payment to a German exporter in 60 days. The importer could purchase a European call option to have the euros delivered to him at a specified exchange rate (the strike price) on the due date. Suppose further that the option premium is AUD0.015 per euro and the exercise price is AUD1.50. Discuss the following status/scenarios of this call option for the Australian importer:

1. If the Spot rate were to rise to AUD1.55 or fall to AUD1.45 indicate whether the option is in-the-money or out-of-the-money for each scenario and will the importer exercise or let the option lapse and why?
2. What is the cost of this option?

Answer 1

Option Premium of Call Option = AUD 0.015 / Euro

Excercise Price of Call Option = AUD 1.5 / Euro

i.

If Spot Rate Rise to AUD 1.55 / Euro

Since we have bought call option on Euro i.e. right to buy the Euro at AUD 1.5 and in market it is trading at AUD 1.55, we would excercise it as it is in the money. A Call Option is said to be in the money, if its spot price is more than strike price.

Here,

Spot Price (AUD 1.55 / Euro) > Strike Price (AUD 1.5 / Euro)

Thus, this option would be in the money and should be excercised as it would be beneficial for importer.

If Spot Rate falls to AUD 1.45 / Euro

Since we have bought call option on Euro i.e. right to buy the Euro at AUD 1.5 and in market it is trading at AUD 1.45, we should not excercise it as it is out of the money. A Call Option is said to be out of the money, if its spot price is less than strike price.

Here,

Spot Price (AUD 1.45 / Euro) < Strike Price (AUD 1.5 / Euro)

Thus, this option would be out of the money and should not be excercised as it would not be beneficial for importer. Rather importer can go to buy Euro in the market as he can buy over there cheaply.

ii. Cost of Option:

Cost of the option is the premium paid on acquiring that option i.e. right. Thus,

Cost of this option = Premium paid on Option i.e. AUD 0.015 / Euro

Thus, cost of option is AUD 0.015