Question

Currently, the spot rate is $1.28/£. As a trader, you believe that the British pound will appreciate significantly in the near future. You decide to speculate by buying a December call option with a strike price of $1.35/£ and a premium of $0.05/£. Please answer the following questions:

1. Explain briefly why buying a call option makes sense in this case.

2. How much is the intrinsic value of the option? And how much is the time value?

3. Please fill in the blanks of the table below.

Spot rate at maturity in December	Exercise or not?	Net profit	Moneyness (ITM, ATM or OTM)
$1.20/£
1.25
1.30
1.35
1.40
1.45

Answer 1

As a trader, we believe that the British pound will appreciate significantly in the near future.

1. Buying a call option on the British pound makes sense because the call option pays off if the British pound appreciates above $1.35/£

2. Strike price = $1.35/£

Spot price = $1.28/£

Spot price < Strike price. So, the call option is out of the money.

Out of the money call option will have an intrinsic value of 0.

The time value of the out of the money call option = call option premium

The time value = $0.05/£

3. The call option will be exercised when the spot rate at maturity > the strike price

Net profit = max(St - X, 0) - premium paid

Net profit = max(St - 1.35, 0) - 0.05

Moneyness

OTM: spot rate at maturity < the strike price
ATM: spot rate at maturity = the strike price
ITM: spot rate at maturity > the strike price

Spot rate at maturity	Exercise or not	Net profit	Moneyness
$1.20/£	Cannot exercise	=max(1.20 - 1.35, 0) - 0.05 =-0.05	OTM
1.25	Cannot exercise	=max(1.25 - 1.35, 0) - 0.05 =-0.05	OTM
1.30	Cannot exercise	=max(1.30 - 1.35, 0) - 0.05 =-0.05	OTM
1.35	Cannot exercise	=max(1.35 - 1.35, 0) - 0.05 =-0.05	ATM
1.40	Exercise	=max(1.40 - 1.35, 0) - 0.05 =0	ITM
1.45	Exercise	=max(1.45 - 1.35, 0) - 0.05 = $0.05/£	ITM