ChapFuturesandOptionsonForeignExchange.ppt

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ChapFuturesandOptionsonForeignExchange

N(d) was calculated using NORMSDIST in Excel, and none of the intermediate steps were rounded—use the memory function of your calculator. Binomial Futures Option Pricing The payoffs of the portfolio are –$0.1683 in both the up and down states. With futures there is no cash flow at initiation. Without an arbitrage, it must be the case that the call option income today is equal to the present value of $0.1683 discounted at i$ = 7.10%: Portfolio Cash Flow = 0.510 × $0.2700 – $0.3060 = –$0.1683 Portfolio Cash Flow = –0.510×$0.3300 = –$0.1683 Call Option Payoff = –$0.3060 Option Payoff = $0 $1.80×1.071 €1.00×1.05 F1($|€) = $1.8360 €1.00 = $1.20×1.071 €1.00×1.05 F1($|€) = $1.2240 €1.00 = Futures Payoff = H × $0.2700 Futures Payoff = –0.510 × $0.3300 $1.50×1.071 €1.00×1.05 F1($|€) = $1.5300 €1.00 = $0.1683 1.071 C0 = $0.1572 = Risk Neutral Valuation of Options Calculating the hedge ratio is vitally important if you are going to use options. The seller needs to know the hedge ratio if he wants to protect his profits or eliminate his downside risk. The buyer needs to know the hedge ratio to decide how many options to buy. Knowing what the hedge ratio is isn’t especially important if you are only trying to value options. Risk Neutral Valuation is a very handy shortcut to valuation. Risk Neutral Valuation of Options We can safely assume that IRP holds: F1($/€) = $1.5300 €1.00 $1.50×(1.071) €1.00×(1.05) = €10,000 = $15,000 $1.20 €1.00 €10,000 × $12,000 = $1.80 €1.00 €10,000 × $18,000 = Set the value of €10,000 bought forward at $1.5300/€ equal to the expected value of the two possibilities shown above: $15,300 = q × $18,000 + (1 – q) × $12,000 €10,000 × $1.5300 €1.00 = Solving for q gives the risk-neutral probability of an “up” move in the exchange rate: $15,300 = q × $18,000 + (1 – q) × $12,000 q = 11/20 = 0.55000 q = $15,300 – $12,000 $18,000 – $12,000 Risk Neutral Valuation of Options Now we can value the call option as the present value (discounted at the USD risk-f

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