Question

1. List the factors that affect currency put options, and briefly explain the relationship that exists for each.

2. Assume that the annual U.S. interest rate is currently 8% and Germany's annual interest rate is currently 9%. The euro's 1-year forward rate currently exhibits a discount of 2%.
(a) Does IRP exist?
(b) Can a U.S. firm benefit from investing funds in Germany using CIA?
(c) Can a German subsidiary of a U.S. firm benefit by investing funds in the United States through CIA?

3. Hudson Co., a U.S. firm, has a subsidiary in Mexico, where political risk has recently increased. Hudson's best guess of its future peso cash flows to be received has not changed. However, its valuation has declined as a result of the increase in political risk. Explain why.

Answer 1

1)

The currency put option gives the buyer of the put option the right to sell the underlying currency at strike exchange rate after a specific period. If the spot rate at the maturity is above the Strike rate put option is not exercised as it can be sold at a higher rate in the market. If the spot rate at the maturity is below the Strike rate, then put option is will be exercised.

The value of currency put option is affected by the following factors:

1) Spot exchange rate: Lower the spot exchange compared to the strike exchange rate, the higher will be the value of the currency put option.

2) Volatility of currency - Higher the volatility of the underlying currency higher will be the chances of the spot exchange going below the strike exchange rate. Hence the value of the currency put option increases with the increase in the volatility of the currency.

3) Maturity Period: Higher the maturity of the currency put option, higher are the chances that the spot exchange rate will become lower than the strike rate at the maturity. Therefore higher the maturity period of the currency put option, higher will be the value of the currency put option.