Question

Assume that a speculator longs a call option on British pounds (with a strike price of $1.32) for $.05 per unit. A pound option represents 10,000 units. Assume that at the time of the purchase, the spot rate of the pound is $1.33 and continually rises to $1.40 by the expiration date.

a- Show the net profit possible for the speculator based on the following expected Spot rates for the British Pound $1.33 ,$1.35, $1,36 ,$1.38 ,$1.40
b- Which market is primarily used by speculators, the forward market or the future market. Explain your answer highlighting the main differences between the forward and future contracts.
c- If the speculator is expecting a currency appreciation which option should he long and which option should he short?

Answer 1

a) The net profit possible for the speculator based on different expected spot rates is as follows: $100, $300, $400, $600, and $800. b) Speculators primarily use the future market, which differs from the forward market in terms of customization, counterparty risk, and flexibility. c) If the speculator expects currency appreciation, they should long a call option with a strike price of $1.32.

Step-by-step explanation:

a) To calculate the net profit, we need to determine the difference between the spot rate and the strike price and multiply it by the number of units. Let's consider the expected spot rates one by one:

• Spot rate $1.33: Net profit = ($1.33 - $1.32) x 10,000 = $100
• Spot rate $1.35: Net profit = ($1.35 - $1.32) x 10,000 = $300
• Spot rate $1.36: Net profit = ($1.36 - $1.32) x 10,000 = $400
• Spot rate $1.38: Net profit = ($1.38 - $1.32) x 10,000 = $600
• Spot rate $1.40: Net profit = ($1.40 - $1.32) x 10,000 = $800

b) Speculators primarily use the future market for trading. The main differences between forward and future contracts are:

• Forward contracts are customized agreements between two parties and traded over-the-counter, while future contracts are standardized agreements traded on exchanges.
• Forward contracts have a higher level of counterparty risk as they rely on the creditworthiness of the parties involved, while futures contracts have lower counterparty risk as they are guaranteed by the exchange clearinghouse.
• Forward contracts have more flexibility in terms of contract size and expiration date, while futures contracts have fixed contract sizes and standardized expiration dates.

c) If the speculator is expecting a currency appreciation, they should long a call option to profit from the increase in the spot rate. In this case, the speculator should long the call option on British pounds with a strike price of $1.32.