Question

You are the manager of a trading company that trades mainly with the companies in Australia. The current exchange rate is HKD4.8423 per AUD (Australian dollar). The information of call option on AUD is shown in the table below.

Type of option	Time to maturity	Exercise Price	Premium per AUD
European Call	3 months	HKD4.9523	HKD0.10

Your company has just bought the call options for AUD500,000.

1. Calculate your company’s potential maximum loss (in dollar terms) in these options. Explain.

2. Calculate the breakeven exchange rate of HKD per AUD for your company in these options.

3. Are the call options in-the-money, out-of-the-money or at-the-money if the exchange rate is HKD4.8612 per AUD? Explain.

4. Calculate your company’s profit/loss in dollar terms (HKD) in these options when the exchange rate is HKD4.9861 per AUD.

5. If these options were American call options, should the option premium be higher or lower than HKD0.10 per AUD. Explain.

Answer 1

1]

maximum loss = total premium paid

total premium paid = premium per AUD * number of AUD

total premium paid = 0.10 * 500,000

total premium paid = HKD 50,000

2]

breakeven exchange rate = exercise price + premium

breakeven exchange rate = 4.9523 + 0.10

breakeven exchange rate = HKD 5.5023 per AUD

3]

These options are out-of-the-money because the exchange rate is lower than the call option exercise price

4]

profit/loss = (exchange rate at expiration - option exercise price - premium) * number of AUD

profit/loss = (4.9861 - 4.9523 - 0.10) * 500,000

loss = HKD 33,100

5]

Option premium should be higher. Premium for American options is higher than premium for European options (all else being equal) because American options can be exercised any time before expiration, whereas European options can only be exercised on expiration date. Therefore, the value of the option is higher in the case of American options