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

1. Buying a call option on the British pound makes sense because the call option pays off if the British pound appreciates.

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

If the spot rate at maturity < the strike price, OTM
If the spot rate at maturity = the strike price, ATM

If the spot rate at maturity > the strike price, ITM

$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