Question

i. Essay question

1. List the factors that affect currency call option premiums and briefly explain the relationship that exists for each

2. Explain the impact of a weak home currency on the home economy, other things being equal?

3. Explain (in detail) why PPP does not hold.

4. Explain when locational arbitrage is possible?

Answer 1

1)These factors are listed below

:•The higher the existing spot rate relative to the strike price, the greater is the call option value, other things equal.

•The longer the period prior to the expiration date, the greater is the call option value, other things equal.

•The greater the variability of the currency, the greater is the call option value, other things equal.

2)A weak home currency tends to increase a country's exports and decrease its imports, thereby lowering its unemployment. However, it also can cause higher inflation since there is a reduction in foreign competition (because a weak home currency is not worth much in foreign countries). Thus, local producers can more easily increase prices without concern about pricing themselves out of the market

3)PPP does not consistently hold because there are other factors besidesinflation that influences exchange rates. Thus, exchange rates will not move inperfect tandem with inflation differentials. In addition, there may not be substitutesfor traded goods. Therefore, even when a country’s inflation increases, the foreign demand for its products will not necessarily decrease (in the manner suggested byPPP) if substitutes are not available

4)Locational arbitrage is possible when a bank's buying price (bid price) is higher than another bank's selling price (ask price) for the same currency.