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View Full Version : ASM pg 122 Question 6.5

Hobogov
February 25th 2009, 12:30 AM
An American company expects to receive L500,000 from sales in England at the end of 6 months. The current exchange rate is \$1.60/L. The company would like to guarantee that is will at least get this rate when it receives the pounds, so that it will receive at least \$800,000. You are given:

Risk free rate (dollars) = 4%.
Risk free rate (pounds) = 7%.
Relative volatility of the currencies is 0.1.
A 2-period Cox-Ross-Rubinstein binomial tree is used to determine the price of options.

Determine the cost of an option, in dollars, which will guarantee the current exchange rate at the end of 6 months.

I understand the solution, but do not understand how they came to the determination that the company should purchase a European put on pounds. Why not a call? I thought maybe put-call parity might be useful, but wouldn't we have 2 unknowns here with the put and call price, making it very confusing in trying to find out which option they are looking for.

ferventforager
February 25th 2009, 01:53 PM
If you were to purchase calls then you would have a position that takes a loss when price declines but make more profit when there is an increase.

Since you expect to recieve pounds in the future and will be converting them to dollars you can think of this as a long position. If you have a long position and purchase puts then you will profit from an increase (net position looks like a call)