1. Currently, 1 Euro is equivalent to 0.88 GBP (i.e., Britishpounds). Assume that the interest rate over one (annual) timestepin Britain is rGB = 3.5%, and in Europe, it is rE = 2.0%. Operatein CRR notation with u = 1.1, and d = 1/u throughout this question,and be careful to specify which currency you are using in allanswers. (a) Assume that your domestic currency is GBP. (i)Calculate the risk neutral probability for an exchange rate option.Let each time step represent one year, so you can use the interestrates given without conversion. (ii) Construct a 4-step binomialtree for the exchange rate. (iii) Assume the strike rate of anexchange rate (European) call option is k = 1.00 GBP/EUR, and theface value is F = EUR10,000. Construct a binomial tree andcalculate the premium of this call option, in GBP. (iv) Using thesame strike rate and face value, calculate the premium of anexchange rate European put (in GBP).
