Answered: Consider a one period binomial model of…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter22: International Financial Management

Section: Chapter Questions

Problem 2P

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Consider a one period binomial model of a currency option on the dollar. The
current (date t = 0) spot exchange rate is S0 = 75 pence per dollar. The spot rate
at the end of the period will be either Su = 100 pence or Sd = 60 pence. The UK
risk-free interest rate over the period is rs = 1/3 (33.3333%) and the US risk-free
rate of interest is rd = 1/4 (25%). There is a call option with a strike price of
K = 68 pence and a forward contract with a price of F = 80 pence. Show how to
use the forward contract and the UK money market to replicate the payoffs to the
call option and hence, find the price of the call option.

Definition Definition Financial market that deals in securities or assets that are short-term in nature. The money market is responsible for keeping up the liquidity of the businesses and the organizations. These securities are usually held for a period of 12 months or less and are issued by institutions that require cash or funds for their short-term cash flow requirements. The money market is regulated by the federal government.

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