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.

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

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

C. 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

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

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

Answer 1

A) Maximum Loss = Option Premium Paid

= AUD500,000* HKD 4.8423

= HKD 2,421,150

B) Breakeven Echange Rate of HKD = Strike Price + Option Premium

= HKD4.9523 + HKD0.10

= HKD5.0523

C) Out of the money.

Call option is said to be

• in the money, if strike price < market price
• at the money, if strike price = market price
• out of the money, if strike price > market price

Here in the given question,

Strike price = 4.9523

Market Rate = 4.8612

Since Strike Price> Market Rate, Option is out of the money.

D) Profit / (Loss) = (Current Exchange Rate - Strike Price) - Option Premium Paid

= HKD (4.9861-4.9523) - HKD0.10

= HKD0.0338 - HKD0.10

= (HKD 0.0662) per AUD

Therefore total loss in HKD = AUD500,000 * HKD0.0662

= HKD33,100

E) American options have a privilage that it can be exercised at any time before expiry which provides the investor with a larger degree of flexibility and control.This privilege means that American options are generally more costly than European style options for the same underlying asset.

Therefore, if these options were American call options, the option premium will be higher than HKD0.10 per AUD.