Will the value of the option increase or decrease

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Reference no: EM132793033

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 fi- nancial 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 volatil- ity raise? Explain your answer.

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

Reference no: EM132793033

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