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Question: Consider the following comment dealing with options written on the eurodollar exchange rate: Some traders, thinking that implied volatility was too high entered new trades. One example was to sell one-year in-the-money euro Puts with strikes around USD1.10 and buy one-year at-the-money euro Puts. If the euro is above USD1.10 at maturity, the trader makes the difference in the premiums. The trades were put on across the curve. (Based on an article in Derivatives Week (now part of Global Capital)).
a. Draw the profit/loss diagrams of this position at expiration for each option separately.
b. What would be the gross payoff at expiry?
c. What would be the net payoff at expiry?
d. Why would the traders buy "volatility" given that they buy and sell options? Don't these two cancel each other in terms of volatility exposure?
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