Question

1. Adam buys a put option on British pounds (contract size is £500,000) at a premium of S0.05/£. The strike price is $1.20/£. (a) Graph the profit/loss on the option contract. (b) What is the break-even price? (a) At what range of spot prices does John make profit? 2. Bank of America buys a call option on euros (contract size is €625,000) at a premium of $0.02 per euro. If the exercise price is $0.98 and the spot price of the euro at date of expiration is $0.95, what is Bank of America's profit (loss) on the call option?

Answer 1

1) We enter into a long put which means that we have the option to sell 1 Pound for $1.20. We will exercise this option when the market price of pound in dollar terms will be lower than 1.2 while when it is higher or at 1.2 then we wont exercise the option and incur the loss of $0.05 of premium that we have paid

(a) So the Profit table can be as follows :

Long Put
Spot price	Exercise price	Premium
Contract value	$                1.20	$               0.05
£   5,00,000.00	Payoff	Profit
2	0	$   -25,000.00
1.8	0	$   -25,000.00
1.6	0	$   -25,000.00
1.4	0	$   -25,000.00
1.2	0	$   -25,000.00
1	$ 1,00,000.00	$     75,000.00
0.8	$ 2,00,000.00	$ 1,75,000.00
0.6	$ 3,00,000.00	$ 2,75,000.00
0.4	$ 4,00,000.00	$ 3,75,000.00
0.2	$ 5,00,000.00	$ 4,75,000.00
0	$ 6,00,000.00	$ 5,75,000.00

• Payoff = (Strike price - Spot Price) x Contract Value
• Profit = (Payoff - Premium x contract Value)

Profit graph will be as follows:

Long Put 57,00,000.00 - 56,00,000.00 $5,00,000.00 $4,00,000.00 $3,00,000.00 $2,00,000.00 $1,00,000.00 S. 05 1 - 15 25 5-1,00,000.00 Profit

(b) Breakeven price is where profit = 0 that is where the graph intersects X- axis

This is some where in between spot price of 1 and 1.2

To calculate the same we have to solve the following equation:

Profit = ((Strike - Spot) - Premium)

0 = ((1.2 - Spot) – 0.05)

Spot =1.15

(c) Profit occurs at spot prices between 1 and 0

2) Call option is the right to buy the euros or the underlying at the strike price but not an obligation so the long party will only exercise the option when the spot price is greater than the strike or the exercise price.

Profit = (Spot - Strike - Premium) x contract value

Profit = (0.98 – 0.95 – 0.02) X 625000

Profit = 6250