You purchased a European foreign exchange option contract to buy 5000 UK pound at the price...

You purchased a European foreign exchange option contract to buy 5000 UK pound at the price of $1.30/£ which expires today. You have paid $140 for the contract. Suppose the spot rate on the expiration date, today, is $1.32/£, what will be your optimal decision for the contract (exercise or not exercise)? Discuss why or why not.

Expert Solution

Since we are having long position in call option( right to buy); and the option is in the money we can exercise the contract;

net profit= 5000*(1.32)-5000*(1.3) -140 = -40 $

---- since we have paid 140$ for purchasing the contract, our net profit will be the profit due to change in exchange rate- option premium as shown above. This value = -40 $

--- By exercising the contract we are able to reduce the loss from -140 $ (spend for option) to -40 $; Hence to reduce the loss we should exercise the contract. This will be the optimal decision.

jeff jeffy answered 2 years ago

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