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Option Price Basics Exercise

Option Price Basics Exercise

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Published by: Vishal on Feb 05, 2011
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03/17/2012

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PRICING & HEDGING OF A EUROPEAN STYLE OPTION :( Para 10.1.1. Of A.V.Rajwade's book 3rd edition )ASSUMPTIONS : YOU ARE WRITING A USD CALL OPTION.CURRENT SPOT :46.56 MONTH FORWARD :47.5STRIKE PRICE :46.5MATURITY :6MTHSVIEWS :FUTURE SPOT WOULD BE SOMEWHEREBETWEEN 44 & 49.LOWEST :44HIGHEST :49WHAT PREMIUM SHOULD BE CHARGED ? YOU BUY 1 USD @ CURRENT FWD RATE I.E.47.5THE OPTION WILL NOT BE EXERCISED IF THE SPOT RATEON MATURITY IS BELOW 46.5OUR ASSUMED CHEAPEST RATE IS :44IF THE OPTION IS NOT EXERCISED, IN THE WORST CASE, WMAY HAVE TO SELL THE USD BOT @47.5AT THE CURRRATE OF44.IF THE FEES CHARGED ARE3.5RS PER $, THEN NOWOULD BE INCURRED IF THE OPTION IS NOT EXERCISED &HEDGE IS TO BE UNWOUND AT THE WORST END OF THE RAEXPECTED.
 
IF, THEREFORE, ON MATURITY THE SPOT IS AT THE WORST YOU DO NOT MAKE ANY PROFIT OR LOSS.IF, ON MATURITY, THE SPOT IS AT THE BEST END I.E.THE OPTION WOULD BE EXERCISED & YOU MAKE A PROFIT2.5RS PER $.IF THE SPOT IS ANYWHERE BETWEEN THE STRIKE PRICE OAND THE WORST END I.E.44, YOU MAKE A PROFILOSS INCURRED ON CANCELLATION OF THE HEDGE WOULTHAN THE FEES RECEIVED.THE FEES CHARGED I.E. 3.5WOULD BE NEEDED ONLY 6HENCE. IT WOULD, THEN, BE SUFFICIENT IF YOU RECEIVE FHAS A FUTURE VALUE OF RS 3.5THE PRESENT VALUE OF RS 3.5IS THUS THE PRICECOMPETITIVE PRICING STRATEGY :FEES :RS3.5HEDGE :1USD BOT @47.5IF FUTURE SPOT IS BELOW THE STRIKE OF46.5THENHEDGE AND THE FEES ENSURE A BREAKEVEN.CAN MORE THAN 1 OPTION BE WRITTEN ?LET US ASSUME THAT THIS NUMBER n =2
 
THE BUYER OF THE OPTION WOULD PAY93ON MBESIDES, THE FEES RECEIVED I.E. RS 3.5ARE AVAILAB1USD WOULD HAVE TO BE BOUGHT AT SPOT RATE ON49THE EQUATION IS :Receipt :Payment :46.5n +3.5 =47.5 +49x (n-1)which is96.5which is96.5n = 2Surplus / (deficit ) : -TO SUMMARIZE :FOR WRITING AN OPTION CONTRACT TO SELL 2STRIKE RATE OF RS46.5FOR A MATURITY OF 6 MONA FEE EQUAL TO PV OF RS 3.5& BUY 1USD FRATE OF RS 47.5BY WAY OF HEDGE.IF THE SPOT ON MATURITY IS BETWEEN 44 &PROFIT. THE WRITER BREAKS-EVEN AT 44 &ASSUMED RANGE.MORE GENERALLY, THE FEE PER USD IS RS.1.75 & THIS 0.50WIDER RANGE :LET US ASSUME THAT THE EXPECTED RANGE IS WIDER ATIF THE OTHER ASSUMPTIONS AS REGARDS THE STRIKE, SP

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