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.

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.