Assume that you use Purchasing Power Parity (PPP) to forecast exchange rates. Suppose you expect that...

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Assume that you use Purchasing Power Parity (PPP) to forecastexchange rates. Suppose you expect that inflation in the UK thenext year will be 1.0%, and inflation in the US will be 5.0%.Assume that you are considering the purchase of five one-yearBritish pound call options from PHLX with a strike price of$1.265/£. The premium is $0.014 per £. The spot rate of the poundis $1.25/£ and the one-year forward rate is $1.26/£ today.
1. Based on your PPP analysis, what will be your expected spotexchange of $/£ in one year?
2. Graph the call option cash flow schedule at maturity. Markoption’s strike price and break-even point.
c. Determine your expected profit (or loss) if the poundappreciates to your expected future spot rate.
d. Determine your expected profit (or loss) if the poundappreciates to the forward rate.

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3.5 Ratings (626 Votes)

aExpected spot exchange rate in current spot rate in 1 US inflation 1 UK inflationExpected spot exchange rate 126 1 5 1 1 131bThe call See Answer

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Assume that you use Purchasing Power Parity (PPP) to forecastexchange rates. Suppose you expect that inflation in the UK thenext year will be 1.0%, and inflation in the US will be 5.0%.Assume that you are considering the purchase of five one-yearBritish pound call options from PHLX with a strike price of$1.265/£. The premium is $0.014 per £. The spot rate of the poundis $1.25/£ and the one-year forward rate is $1.26/£ today.1. Based on your PPP analysis, what will be your expected spotexchange of $/£ in one year?2. Graph the call option cash flow schedule at maturity. Markoption’s strike price and break-even point.c. Determine your expected profit (or loss) if the poundappreciates to your expected future spot rate.d. Determine your expected profit (or loss) if the poundappreciates to the forward rate.