What is the largest lower bound for this type of option

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Reference no: EM132172438

Question - A Norwegian producer of oil-platform supply-vessels has sold a ship to a US company for US 20 million. The payment is due in 180 days. The current exchange rate is NOK 8.500/USD. The Norwegian company wants to make sure that it receives at least NOK 170 million for the ship in 180 days and approaches the bank for which you are working. Your task is to provide it with a quote for an option that guarantees that in 180 days from now the Norwegian company will be able to convert the US 20 million at least at a rate of NOK 8.5/USD. The 180-day interest rate is 1.5% p.a. in Norway and 2% p.a. in the US.

1. During the first telephone talk, your client asks you which kind of option you would recommend and asks for a quick estimate of the cost of this insurance. Having for the moment only the numbers given above you tell him the largest lower bound for a European option with the appropriate strike price.

2. Your client is also considering buying an American option with the same strike price. What is the largest lower bound for this type of option?

3. Your client decides to go for the European option. You tell him that you will have the exact price ready until tomorrow. How much does the retailer have to pay for this insurance? Use the 2-period binomial option pricing model to calculate the price of a European option with the appropriate strike price. The exchange rate volatility is 0.20.

4. Seeing your quote, the client realizes that hedging with this option is cheaper than last year. The client wonders why the price for an option with the same strike price and maturity was higher last year. What could have been the reason for the higher price last year?

Reference no: EM132172438

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