A U.S. investor is planning to do some speculation in the foreign exchange marke
ID: 2761606 • Letter: A
Question
A U.S. investor is planning to do some speculation in the foreign exchange market. a] Define speculation. Briefly describe how an investor might use i] futures in foreign exchange and ii] foreign exchange options, to speculate. What are the main benefits each type of contract and how do both compare to forward contracts for the purpose of speculation? b] Suppose the investor chooses to buy a pound futures contract for 62,500, the futures contract price is 2 USD per pound, and the maturity date of the contract is the third Wednesday in June 2016. If the future's price on May 10th, 2016 is 2.1 USD per pound, calculate the profit or loss from liquidating this contract on that date. What is the profit/loss from liquidation if the future's price is 1.9 USD per pound on May 10th 2016? c] Suppose the investor chooses to buy a pound call option for 62,500 with a strike price of 2 USD per pound. The maturity date of the contract is the third Wednesday in June 2016. If the spot rate on May 10th, 2016 is 2.1 USD per pound, do you think the investor should exercise the option on this date? Is the ption is in the money, out of the money or at the money? Calculate the payoff from exercising. Explain why the investor might NOT exercise the option at this date. d] Suppose that the spot rate on the maturity date of the futures contract in b] and the option in c) is 1.9 USD per pound. Draw the value profiles of the future and option on the same diagram and label the diagram carefully, showing what the expiration value of each derivative is. e] Briefly describe what the value of an option's premium reflects and to whom it is paid and when. Would you take account of the premium you had paid in deciding whether or not to exercise an option? Explain.Explanation / Answer
Answer
Answer (e )
An option’s premium has two main components: intrinsic value and time value.
Intrinsic Value (Calls)
A call option is in-the-money when the underlying security's price is higher than the strike price.
Intrinsic Value (Puts)
A put option is in-the-money if the underlying security's price is less than the strike price. Only in-the-money options have intrinsic value. It represents the difference between the current price of the underlying security and the option's exercise price, or strike price.
Time Value
Time value is any premium in excess of intrinsic value before expiration. Time value is often explained as the amount an investor is willing to pay for an option above its intrinsic value. This amount reflects hope that the option’s value increases before expiration due to a favourable change in the underlying security’s price. The longer the amount of time available for market conditions to work to an investor's benefit, the greater the time value.
The premium is the price a buyer pays the seller for an option. The premium is paid up front at purchase and is not refundable - even if the option is not exercised.
No, we will not take account of premium we had paid in deciding whether or not to exercise option because premium paid is sunk cost and it has not relevance for making decision whether or not to exercise option. Strike price of option is compared with current market price of underlying security to make decision whether to exercise option or not.
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