Question

Assignment 1 (assessment worth 10%)
Due Date Monday 8^th May by 5pm GMT+8

[Submission will be strictly observed. Make submission via Turnitin]

Question 1

An Australian investor holds a one month long forward position on USD. The contract calls for the investor to buy USD 2 million in one month’s time at a delivery price of $1.4510 per USD. The current forward price for delivery in one month is F= $1.5225 per USD. Suppose the current interest rate interest is 5%. What is the value of the investor’s position? (3 marks)

Question 2

A speculator can choose between buying 100 shares of a stock for $40 per share or buying 1000 European call options on the stock with a strike price of $45 for $4 per option. For the second alternative to provide a superior payoff to the first alternative at option maturity, must the stock price be above $50 or below $50 explain? (3 marks)

Question 3

Explain in detail the difference between the following terms: (4 marks)

(a) Intrinsic value of an option.

(b) Price of an option.

(c) Exercise price of an option.

Answer 1

1)Value of investor position after one month=(spot after 1 month-contract price)* $ 2million

=(1.5225-1.4510)* $ 2million

= $0.143 million

Value of position today based on

one month actual forward price =0.143 m/{1+(0.05/12)}

=$0.143m/1.004166666

=$0.1424066 millions

2) When stock price =$50

Pay off from stock =(50-40)*100=$1000

Pay off from call option =[(50-45)*10000]-(4*1000)

=$1000

At stock price =50 pay off from both the alternatives are same.Now as the price increases from $50,the payoff from call option will be 10 times more (since 1000 call option & stocks are only 100) than stock.

So for second alternative to be superior,the stock price must be above $50.

3)

(a) Inthrinsic value of option-The intrinsic value of call options is the difference between the underlying stock's price and the strike price. Conversely, the intrinsic value of put options is the difference between the strike price and the underlying stock's price. In the case of both call and put options, if the calculated value is negative, the intrinsic value is given as zero.

(b) Price of an option-Intrinsic value and extrinsic value combine to make up the total value of an option's price. The extrinsic value, or time value, takes into account the external factors that affect an option's price, such as implied volatility and time value.Inthrinsic value is explained above.

(c) Exercise price of an option-An exercise price is the price at which the holder of a call option has the right, but not the obligation, to purchase the contracted no.. Of  sharesof a particular underlying stock by the expiration date.Similary in case of put option,the holder has right,but not the obligation to sell the contracted no. Of shares of underlying stock by expiration date at exercise price.