Question

a) Under purchasing power parity, what’s the correlation between the inflation rate and the exchange rate?

b) What’s the difference between a European option and an American option?

c) What’s a foreign currency futures contract?

d) How can forward rate agreements be used to hedge against interest rate risk?

e) What happens to the option price in case the option expires worthless and in case the investor chooses to exercise it?

Answer 1

A)under purchasing power parity the correlation between inflation rate and exchange rate is that when inflation is high exchange rate would be lower and when exchange rate is high the inflation would be lower so in order to arrive at purchasing power parity

B)difference between an European call option and American option is that European option cannot be exercised before maturity whereas American option can be exercised before maturity

American options are more flexible than European options

C) foreign currency futures contract is entering into futures contract in currency market to protect against fluctuations in in currency markets through standardized contracts which will have the application of getting exercised before the due date

D)forward rate agreement can be helpful in hedging against interest rate risk as they will provide an option to take exposure in the the forwards Market by entering at prescribed rate which will be customised and acceptable to both the parties

E) in case of the option pricing expiring worthless, the option premium which have been paid by the option holder will be completely lost and the option holder will loss maximum up to the premium paid.