How a financial institution would hedge a short position

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Question - The domestic risk-free rate is 3% per annum, the foreign risk-free rate is 5% per annum, the exchange rate volatility is 12% and the time to maturity is 15 months. Interest rates are continuously compounded.

(i) Use a three-time-step tree to value an at-the-money American put option on a currency when the initial exchange rate is 1.2.

(ii) Calculate the option ? at t = 0 and after the first 5 months.

(iii) Suppose the exchange rate increases after 5 months. Explain how a financial institution would hedge a short position in the option in the first 5 months. How would you answer change if the exchange rate decreases after 5 months?

(iv) Will the value of the option increase or decrease if the exchange rate volatility raise? Explain your answer.

(v) Will the value of the option increase or decrease if the domestic interest rate decrease? Explain your answer.

Reference no: EM132800481

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