Question

Consider an option to buy £10,000 for €12,500. In the next period, if the pound appreciates against the dollar by 37.5 percent then the euro will appreciate against the dollar by ten percent. On the other hand, the euro could depreciate against the pound by 20 percent.

Big hint: don't round, keep exchange rates out to at least 4 decimal places.

		Spot Rates			Risk-free Rates
S0($/€)		$1.60 = €1.00		i$	3.00%
S0($/£)		$2.00 = £1.00		i€	4.00%
S0(€/£)		€1.25 = £1.00		i£	4.00%

Calculate the current €/£ spot exchange rate.

Answer 1

Calculate the cross rate between the euro and pound as follows:

€/£ = (€/$)* ($/£) Here, Divided and multiply $, to find the cross rate, because the rates are given in dollars.

Here, €/$ = 1/1.60

$/£ = 2

€/£ = (1/1.6) * 2

€/£=1.25

Therefore, the cross rate is 1.25.