Question

Consider a European put option on British pounds with an exercise price of $1.60/£. You pay an option premium of $0.04/£ to buy the put option today. You decide whether to exercise the put option on the expiration date.

1. (6 points) In the following table, fill in the option payoff per pound as well as net profit (or loss) per pound based on the listed possible spot rates of dollars per pound at expiration (Net profit or loss = Payoff – Premium). Please show how you find the payoff and profit (loss) for each spot rate at expiration here.

Possible spot rate of dollars per pound at expiration	$1.48	$1.52	$1.56	$1.62	$1.66
Option             payoff            per pound
Net profit (loss) per pound

2. (2 points) At what spot rate of dollars per pound on the expiration date would you break-even (profit = 0)?

Answer 1

If the Pound weakens below $1.60/£ , there is a profit and if Pound strengthens above $1.60/£, there would be a loss equal to the option premium.

Option premium = $0.04/£

Strike price	$1.60	$1.60	$1.60	$1.60	$1.60
Possible spot rate of dollars per pound at expiration	$1.48	$1.52	$1.56	$1.62	$1.66
Option payoff per pound	$0.12	$0.08	$0.04	0	0
Net profit (loss) per pound	$0.08	$0.04	$0.00	-$0.04	-$0.04

Here, the Option payoff per pound = Strike price - Possible spot rate of dollars per pound at expiration

If the put option is out of the money ( ie the spot price is above the strike price), then option payoff=0

Net profit/loss = Option payoff per pound - Option premium paid

Net profit/loss per pound = Option payoff per pound - $0.04

a. Break-even point is when the profit equals 0.

From the above table, at spot-rate $1.56 per pound, the profit is 0

Hence, spot-rate $1.56 per pound is the break-even