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 Decemberput 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

1. Buying a put option makes sense because we believe that the British pound is expected to depreciate significantly. If our view is correct that the British pound depreciates, then the put option pays off really well.

2. Put option premium = $0.05/£

The spot rate ($1.33/£) < The strike price ($1.35/£).

The put option is in the money.

The intrinsic value = The strike price - The spot rate

The intrinsic value = 1.35 - 1.33

The intrinsic value = $0.02/£

The time value = Put option premium - The intrinsic value

The time value = 0.05 - 0.02

The time value = $0.03/£

3. We exercise put option when Spot rate at maturity < The strike price

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

If The spot rate < The strike price ($1.35/£): ITM

If The spot rate =  The strike price ($1.35/£). ATM

If The spot rate > The strike price ($1.35/£). OTM

Spot rate at maturity in December	Exercise or not?	Net profit	Moneyness (ITM, ATM or OTM)
$1.20/£	Yes	= max(1.35 - 1.20, 0) - 0.05 = 0.15 - 0.05 =$0.10/£	ITM
1.25	Yes	= max(1.35 - 1.25, 0) - 0.05 = 0.10 - 0.05 = 0.05	ITM
1.30	Yes	= max(1.35 - 1.30, 0) - 0.05 = 0.05 - 0.05 = 0	ITM
1.35	No	= max(1.35 - 1.35, 0) - 0.05 = 0 - 0.05 = -0.05	ATM
1.40	No	= max(1.35 - 1.40, 0) - 0.05 = 0 - 0.05 = -0.05	OTM
1.45	No	= max(1.35 - 1.45, 0) - 0.05 = 0 - 0.05 = -0.05	OTM

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