Consider an Option to Buy €12,500 for £10,000 State the Composition of the Replicating Portfolio; Your Answer Should

question 52

Essay

Consider an option to buy €12,500 for £10,000.In the next period,the euro can strengthen against the pound by 25 percent (i.e.,each euro will buy 25 percent more pounds)or weaken by 20 percent.
Big hint: don't round,keep exchange rates out to at least 4 decimal places.

$\begin{array}{lll}&spot Rates&Risk-tree Rates\\S_{0}(\$ / €) & \$ 1.60=€ 1.00&i \$ 3.00 \% \\S_{0}\left(\$ / £)\right. & \$ 2.00=£ 1.00&i €4.00 \% \\S_{0}\left(€ /£)\right. & € 1.25=£ 1.00&i £4.00 \%\end{array}$ State the composition of the replicating portfolio; your answer should contain "trading orders" of what to buy and what to sell at time zero.

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Definitions:

Reconcile

The process of ensuring that two sets of records, typically bank statements and a company's cash account, are in agreement.

Bank Service Charges

Fees charged by banks for account maintenance, transactions, and other financial services.