Question

• Information for Questions 17 – 20. Tom owns a patent, and expects to receive a royalty payment of 3 million pounds next month. He is interested in protecting these receipts against a drop in the value of the pound. He can:

  • Sell forward a 30 day contract at a price of $1.65 per pound, or
  • He can buy a pound put option with a strike price of $1.66 at a premium of 2.0 cents ($.02) per pound.

  The spot price of the pound is currently $1.67, and the pound is expected to trade in the range of $1.62 to $1.70. Tom feels that the price of the pound in 30 days will likely be $1.63. Assume the interest rate in the US is 5%.

  17.    Tom expects the put option to be __________ in 30 days.

  A. out-of-the-money             

  B. in-the-money                             

  C. deep-in-the-money    

  D. at-the-money                             

  E. meeting-the-money.        

• QUESTION 18

  18.    If Tom uses the forward contract, he will receive, in net, ________ for his royalty payment if the spot price of the pound is at its low value, $1.62, and ______ if the pound hits its high value, $1.70.

  A. 4.98M; 5.10M                             

  B. 4.95M; 4.95M

  C. 4.86M; 5.10M   

  D. 4.86M; 4.95M                   

  E. none of the above

• QUESTION 19

  19.    If Tom uses the put option, he will receive, in net, ____ for his royalty payment if the spot price of the pound in the future is at its low value, $1.62, and ____ if the pound hits its high value, $1.70.

  A. 4.980M; 4.980M                        

  B. 4.980M; 5.100M                                  

  C. 4.920M; 5.100M     

  D. 4.917M; 5.100M                        

  E. 4.917M; 5.037M

• QUESTION 20

  20.    Suppose Tom purchases the put option. Suppose too that the person on the other side of the contract, Kerry, also in the US, simply uses the spot market to complete her transaction with Tom and close out her position in dollar terms.  If the spot price of the pound in the future is at its low value, $1.62, Kerry makes ____________ and if the pound hits its high value, $1.70, she makes __________ (the answer below is expressed in dollar terms).

  A. +.060M; +.060M                        

  B. −.060M; +.060M

  C. −.057M; +.063M     

  D. −.12M; +.025M                 

Answer 1

17. Tom expects the put option to be in-the-money in 30 days.

The put option is in-the-money when the spot price is less than the strike price. Here the spot price is $1.63 and the strike price is $1.66.

18. If Tom uses the forward contract, he will receive, in net, $4.95M for his royalty payment if the spot price of the pound is at its low value, $1.62, and $4.95M if the pound hits its high value, $1.70.

No matter at what direction the spot price moves, Tom will receive $4.95M for his royalty because he has locked in the price in a forward contract. He will receive 1.65*3 million = $4.95M even if the spot is 1.62 or 1.70.

19. If Tom uses the put option, he will receive, in net, 4.980M for his royalty payment if the spot price of the pound in the future is at its low value, $1.62, and 5.100M if the pound hits its high value, $1.70.

In this case Tom will prefer to convert his royalty at a higher price regardless of what price prevails in the market or what is the strike price of the put option.

When Spot Price is $1.62, then Tom will receive 3 million * $1.66= $4.980M (he will exercise the put option).

When Spot Price is $1.70, then Tom will receive 3 million * $1.70= $5.100M (he will not exercise the put option)

20.    Suppose Tom purchases the put option. Suppose too that the person on the other side of the contract, Kerry, also in the US, simply uses the spot market to complete her transaction with Tom and closeout her position in dollar terms.  If the spot price of the pound in the future is at its low value, $1.62, Kerry makes −.12M and if the pound hits its high value, $1.70, she makes +.025M .

The person on the other side of the contract, Kerry, is the seller of the put option and thus has a short position in this case.  If the spot price of the pound in the future is $1.62, Kerry makes (1.62 - 1.66) * 3 million = - 0.12, he has to buy the pound at $1.66 when it is only worth $1.62 and if the spot price of the pound in the future is $1.70, Kerry makes +0.025 and there no need to buy the pound from Tom and the premium of 0.02 received could be her profit.