The U.S. three-month interest rate (unannualized) is 2%. The Australian three-mo

Question

The U.S. three-month interest rate (unannualized) is 2%. The Australian three-month interest rate (unannualized) is 4%. Assume interest rate parity exists. The expected inflation over this period is 7% in the U.S. and 4% in Australia. A call option with a three-month expiration date on Australian dollars is available for a premium of $.01 and a strike price of $.88. The spot rate of the Australian dollar is $.91. Assume that you believe in purchasing power parity.
Determine the dollar amount of your profit or loss from buying a call option contract specifying $110,000 Australian dollars. Show all work.

Explanation / Answer

1 Australian $ = $0.91

Applying PPP,

Aafter 3 months,

1.04 Australian $ = 0.91 x 1.07

1 Australian $ = $ 0.93625

Profit on call option = [0.93625 - 0.88 - 0.01] x 100000

= $4625

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