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Consider an Option to Buy €12,500 for £10,000 Find the Value of the Call

question 11

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.

spotRatesRisktreeRatesS0($/)$1.60=1.00i$3.00%S0($/£)$2.00=£1.00i4.00%S0(/£)1.25=£1.00i£4.00%\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} Find the value of the call.


Definitions:

Non Est Factum

A defense in contract law allowing a signing party to void the contract due to a fundamental misunderstanding of its nature.

Guaranteed Indebtedness

Obligations for which a third party guarantees payment in case the primary debtor fails to pay.

Poor Eyesight

A condition where a person's vision is impaired, making it difficult to see clearly without the aid of corrective lenses or surgery.

Undue Influence

Improper or wrongful pressure exerted on one person by another in order to coerce an action, contrary to their will.

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