Question

You are offered a chance to buy a put or call option from a currency dealer with a strike price of USD 0.8300/CHF with June expiration and premium of USD 0.0050/CHF. Your Magic 8 Ball tells you that the spot exchange rate will reach USD 0.8400/CHF sometime between now and June. With your entire savings, or USD 10,000, you want to speculate using the options to make some profits to finance your graduation bash. If you do, i) which option should you buy, ii) what is your notional principal, iii) total net profits, and iv) the rate of return on this speculation, assuming your Magic 8 Ball is right? What is your loss if Magic 8 Ball is wrong? (Hint: Assume the speculation period is one month.)

Answer 1

Answer 1) Call option is the most suitable in the situation as it provide right to buy at pre-decided price of USD 0.8300/CHF in this case .

Answer 2) Notional principle = Total amonut of derivative contracts = Value of one contract * number of contracts purchased = Value of one contract * ( TotalCapital/ Premium of one contract)

= 0.8300 * ( 10000/0.0050) = $ 1660000  

Answer 3) Total Net Proft = Profit from One Contract * number of contract

Profit from one contact = SPot price at time of maturity - ( Strike price+ Premium paid) =$ 0.0050

Total Net Profit = 0.0050 * (10,000/0.0050) = $ 10,000

Answer 4) Rate or return on speculation = Total net profit / Principle invested *100

= 100% for a month = 1200% annulaised return ,In terms of Compounding of the same simple interest .

The maximum loss is case of any option investment = premium paid

So,if Magic 8 Ball is wrong , total loss will be the principle invested in the contract , $10,000.