Question

In anticipation of a depreciation of the British pound, you decide to write a single call option with an exercise price of $1.14 and a premium of $0.79. Each option contract covers 62,500 British pounds. If the spot rate at the option's maturity turns out to be $1.27, what is your total profit or loss for the call option contract (assuming the buyer of the option acts rationally)?

Answer 1

Writing a call option with an exercise price lower than the maturity spot rate results in a loss per unit, but the premium collected on the contract can result in an overall profit. In this case, there's a net profit due to the significant premium earned on the contract.

Step-by-step explanation:

If you write a single call option on the British pound with an exercise price of $1.14, a premium of $0.79, and the spot rate at maturity is $1.27, the buyer of the option will act rationally by exercising the option, because the market price ($1.27) is above the exercise price ($1.14).

You, as the writer of the option, will incur a loss due to the difference between the market price and the exercise price.

To calculate the total loss, first, you need to determine the loss per pound, which is the spot rate ($1.27) minus the exercise price ($1.14), resulting in a loss of $0.13 per pound.

Then, multiply this by the number of pounds in the contract, 62,500, which equals a loss of $8,125.

Finally, subtract the premium you received for writing the option, 62,500 pounds × $0.79 premium = $49,375.

Your net loss is the total loss from the exercised option minus the premium received, $8,125 - $49,375, which is a net profit of $41,250.