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Use binomial option pricing model for this question. Suppose the current spot rate for USD/CHF is 0.7000. You need to find the one-year call option price of USD/CHF with the exercise price of 0.6800 USD/CHF. Assume that our future states will be either 0.7739 USD/CHF or 0.6332 USD/CHF.
1) What are the payoffs of the call option (for both states)?
2) What is the hedge ratio of the call option?
3) Assume you can trade CHF denominated risk-free bond with the face value of 1 CHF and the maturity of one year. Use this bond and compute call option premium (using the binomial option pricing). To this end, at first, assume you buy one unit of the bond. A) what is the dollar amount of payoffs from this bond in one year? B) if USD/CHF spot rate in one year is 0.6332, how much do you need to borrow today in dollar to make your net cash flow from the CHF bond and USD borrowings? Assume the interest rate in the U.S. is 2% (per annum). C) if you borrow the dollars as you answered for B), what will be your net payoff when USD/CHF is 0.7739 in one year? D) Using C), what is the call option premium? Assume the risk free rate in Switzerland is 0%.
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