Question

Currently, the spot rate is $1.33/£. As a trader, you believe that the British pound will depreciate significantly in the near future. You decide to speculate by buying a December put 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 put 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

The spot rate is $1.33/£.

The strike price is $1.35/£.

We believe that the British pound will depreciate significantly in the near future.

1. Buying a put option on British pound makes sense because we believe that British pound is going to depreciate. Put option pays off when the British pound depreciates.

2. The spot rate is < the strike price. So, the put option is in the money.

The intrinsic value of a put option = strike price - spot price

The intrinsic value = 1.35 - 1.33 = $0.02/£.

The time value = Put option price - the intrinsic value

The time value = 0.05 - 0.02 = $0.03/£.

3. A put will be exercised if the spot price at expiry (1.33) < the strike price (1.35). Else, it is not exercised

Profit = max(X - St, 0) - Put option price

Profit = max(1.35 - St, 0) - 0.05

ITM: St < Strike price

ATM: St = Strike price

OTM: St > Strike price

St	Exercise or not	Profit	Moneyness
$1.20/£	Exercised	=max(1.35 - 1.20, 0) - 0.05 = 0.15 - 0.05 = 0.10	ITM
1.25	Exercised	=max(1.35 - 1.25, 0) - 0.05 =0.10 - 0.05 = 0.05	ITM
1.30	Exercised	=max(1.35 - 1.30, 0) - 0.05 =0.05 - 0.05 = 0	ITM
1.35	Not exercised	=max(1.35 - 1.35, 0) - 0.05 =0 - 0.05 = -0.05	ATM
1.40	Not exercised	=max(1.35 - 1.40, 0) - 0.05 =0 - 0.05 = -0.05	OTM
1.45	Not exercised	=max(1.35 - 1.45, 0) - 0.05 =0 - 0.05 = -0.05	OTM