FINA3326 APPLIED FINANCIAL MANAGEMENT
TUTORIAL SOLUTIONS 03
Prepare for Week 04 Discussion
For the tutorial prepare questions 1 to 5 and Textbook Chap 5 Q40 and Q41
The remaining questions are for revision.
1. Imagine that the interbank AUD / USD exchange rate was 0.8062 / 0.7995 and the five-month forward
margins on the AUD were -93 / -90.
a) Do you think the AUD was selling at a forward premium or a forward discount to the USD?
Why?
In this case we can see from the negatives that we need to subtract the points, so the AUD was
selling at a forward discount and conversely the USD was selling at a forward premium (note that
if you check today’s market prices the AUD is selling at a forward premium to the USD – in the
short term, unlike in this question).
Alternatively, if you know the interest rate differential between the two countries you could easily
determine whether you should be adding or subtracting the points (see parity condition lectures).
As a simple check on your answer, we know that forward quotes are inherently riskier, so we
would expect dealers to compensate themselves above that which they require for dealing in the
spot rate by increasing the bid/ask spread. Though rounding and liquidity issues may confuse this
test for very small numbers and for short durations.
b) Calculate the outright five-month forward quote.
Historically forward contracts in the interbank market are traded against the USD (with one
exception, EUR/GBP). They are quoted as the value of the non-US currency in USD.

We can solve this by converting the spot quote in the paper to a direct quote on the AUD (0.7995 /
0.8062) then adding the forward margins to the interbank quotation. Interbank forward quotations
are quoted in Direct Terms, yet we were given an indirect quotation in the spot.
0.7902 / 0.7972 AUD / USD (70 point spread) Direct quote on the AUD
Which is the same as:
0.7972 / 0.7902 AUD / USD, Indirect quote on the USD.

c) Using the direct bid quotation, find the annualised forward premium or discount on the AUD.
100
days ofnumber contract forward
360x
Spot
Spot - Forward 
100
150
360x
0.7995
0.7995-0.7902  2.79%- 
2. Ford buys a Swiss Franc put option (contract size is CHF 62,500) at a premium of $0.01 per Swiss
Franc. If the exercise price is $0.61 and the spot price of the franc at the date of expiration of $0.615,
what is Ford’s profit (loss) on the put option?
The right to sell Swiss francs at $0.61 when the spot price is $0.615 is worthless. Hence, Ford will
allow the option to expire unexercised and take a loss on the put option equal to its put premium of
.01 x 62,500 = $625.
3. Which contract is likely to be more valuable, an American or a European call option? Explain.
The American call option is likely to be more valuable since it can be exercised at any time prior
to maturity, unlike the European option, which can be exercised only at maturity. The option to
exercise early can be valuable when interest rates on the two currencies differ.
4. In the lecture notes the value of the call option is shown as approaching its intrinsic value as the
option goes deeper and deeper in-the-money or further and further out-of-the-money. Explain why
this is so.

As the call option moves further out-of-the-money, the chances that it will expire unexercised and
worthless increase, bringing it closer to its intrinsic value of zero. Alternatively, as the option goes
deeper in-the-money, the chance that the exchange rate will fall below the exercise price declines,
increasing the probability that the option will be exercised eventually at a profit equal to its
intrinsic value.

5. Resources:
https://www.asx.com.au/investors/learn-about-our-investment-solutions/warrants
http://www.asx.com.au/documents/resources/UnderstandingWarrants.pdf
https://www.asx.com.au/PDF/18-051CTW.pdf
https://www2.asx.com.au/markets/trade-our-cash-market/asx-investment-products-
directory/etps#currency

(a) How do warrants differ from options?
ASX description:
Warrants and options are both a form of derivative instrument. They derive their value from an
underlying instrument such as a share or an index.

ASX grants permission for warrants to be traded on its market (called ‘admission to trading
status’) on the application of warrant issuers. ASX does not guarantee the performance of warrant
issuers nor does it vouch for the accuracy of their product disclosure statements.

Key differences include:
 Warrant trades are settled on CHESS, whereas options trades are settled by the Australian
Clearing House (ASX Clear)
 Option terms are standardised and set by ASX, whereas the terms of warrant series are set by the
issuer and vary from one warrant to another
 Warrants are issued by a third party (e.g., a bank) while options are listed by ASX
 Result (Key difference): Warrant holders are exposed to the credit risk of the issuer, while ASX
Clear guarantees the performance of option contracts
(b) What types of FX derivatives are offered on the ASX?
Sources: ASX Descriptions & Product Disclosure Statements

MINIs
MINIs are a currency tracking product that provide investors with leveraged exposure to a number of currency
pairs. MINIs are similar in nature to CFDs as they do not have an expiry date and track the underlying
currency on a one for one basis.

They also contain an in-built stop loss to ensure you cannot lose more than your initial outlay.

Currency MINI longs give traders leveraged exposure to the Australian Dollar (AUD) rising against a selected
currency. Conversely Currency MINI shorts give traders leveraged exposure to the AUD falling against a
selected currency.

The pricing components of a Currency MINI:
Value of a MINI Long Australian Dollar versus selected currency = [Level of the Exchange Rate – Strike Price]
x Multiplier / Exchange Rate
Value of a MINI Short Australian Dollar versus Offshore Currency = [Strike Price – Level of the Exchange
Rate] x Multiplier / Exchange Rate
Call and Put Trading Warrants
Holders of currency warrants may exchange an amount of foreign currency for Australian dollars on or before
the expiry date. The value of the warrant rises and falls in line with movements in the exchange rate. For
example, holders of AUD/USD call warrants benefit from an increase in the AUD/USD exchange rate and
holders of AUD/USD put warrants benefit from a decrease in the AUD/USD exchange rate.

Call and put warrants are similar in nature to exchange traded options. The key difference between a call and
put warrant and an exchange traded option is that the terms are set by a warrant issuer as opposed to the ASX.

Call and Put currency warrants allow investors to gain leveraged exposure to the Australian Dollar rising or
falling against the US Dollar on or before a particular date.

They offer exposure to an underlying currency by giving you the right to exchange an amount of foreign
currency for Australian dollars on or before the expiry date.

Call and Put Currency warrants are available over the AUD/USD currency.

Each warrant is a contract between the warrant issuer and the holder. You are therefore exposed to the risk
that the issuer will not perform its obligations under the warrant. Margins are not required for warrants as you
only sell a warrant to close out an existing warrant position. In contrast, exchange traded options can be sold
as an opening transaction.

Currency Exchange Traded Funds (ETFs)
Currency ETFs can provide investors with the opportunity to gain exposure to the performance of selected
foreign currencies. Currency ETFs are non-leveraged and are generally lower in cost when compared to
holding a foreign currency account with a bank.
Currency ETFs are available over the Australian / United States dollar (ASX code is USD), Australian /
British Pound (ASX code POU) and the Australian / Euro (EEU). They are also offered by ANZ e.g., ZCNH
(for the Renminbi). NOTE: Many of these products move in and out of being offered on the ASX and
others have no active trading! See the trading volumes after clicking on the product
codes.
CHAPTER 5
40. Uncertainty and Option Premiums. At 10:30 a.m., the media reported news that the Mexican
government political problems were reduced, which reduced the expected volatility of the Mexican
peso against the dollar over the next month. The spot rate of the Mexican peso was $.13 as of 10 a.m.
and remained at that level all morning. At 10 a.m., Hilton Head Co. purchased a call option at the
money on 1 million Mexican pesos with an expiration date one month from now. At 11:00 a.m.,
Rhode Island Co. purchased a call option at the money on 1 million pesos with a December expiration
date one month from now. Did Hilton Head Co. pay more, less, or the same as Rhode Island Co. for
the options? Briefly explain.
ANSWER: Hilton Head Co. paid a higher premium than Rhode Island Co. because the by the time
Rhode Island Co. purchased the call option, the expected volatility of the currency was reduced.

41. Speculating with Currency Futures. Assume that one year ago, the spot rate of the British
pound was $1.70. One year ago, the one-year futures contract of the British pound exhibited a
discount of 6%. At that time, you sold futures contracts on pounds, representing a total of 1,000,000
pounds. From one year ago to today, the pound’s value depreciated against the dollar by 4 percent.
Determine the total dollar amount of your profit or loss from your futures contract.
ANSWER: Spot rate 1 year ago = $1.70
Forward rate 1 year ago = $1.70 x (1– .06) = $1.598
Dollars received for 1,000,000 pounds = 1,000,000 x $1.598 = $1,598,000.
Spot rate of pound = 4% less than 1 year ago = $1.632
Dollars that are now required to buy the 1,000,000 pounds = $1,632,000.
Profit = $1,598,000 - $1,632,000 = -$34,000 [loss]
Practice Solutions 03
Additional Questions Provided for Revision Purposes Only (Not for the tutorial)
6. Boreas wants to speculate on the value of the Swiss Franc which he believes is going to rise in value
over the next 3 months. On the Philadelphia Stock Exchange he finds December Swiss Franc call
options with a strike rate of USD / CHF 1.23. The contract has a premium of 2c US and is of size
62,500 CHF.
The current spot price is 1.2390. The current forward rate is 1.2280
a) Are the options in or out of the money? What is the intrinsic value of the option? (careful) What is
the time value of the option?
Spot 1/1.239 = 0.8071 USD
Strike 1/1.23 = 0.8130 USD
Call options are OTM as you would rather buy the CHF at 0.8071 than 0.8130.

Intrinsic value = 0, Time value = 2c US per unit of FC, (2c)(62,500)=1250 USD.
b) What is the percentage return to holding the option and the percentage return to holding the
currency in the spot market if the final spot rates are (1) 1.2658, (2) 1.2048 or (3) 1.15?
Note: Why do you think the speculator has chosen to hold a call option? It is possible this is a
good idea, but not necessarily true… Think about the lecture notes on speculation.

Spot Market
1 USD -> 1.2390 CHF -> 1.2390 / 1.2658 USD
=0.9788 (2.1% loss)
1USD -> 1.2390 CHF -> 1.2390 / 1.2048 USD
=1.0284 (2.84% profit)
1USD-> 1.2390 CHF -> 1.2390 / 1.15 USD
=1.0774 (7.74% profit)

Options Market
1250 USD will buy you 1 Option on CHF

Strike 0.8130 USD
a) Final Spot 1/1.2658 = 0.7900 USD
Option is OTM

Loss of Premium -100%

b) Final Spot 1/1.2048 = 0.8300 USD
Option is ITM

Call Option Payoff = (Asset Price – Strike) * Underlying Value
= (1/1.2048 – 1/1.23)*62,500
Receive 1062.8 USD (With no prior rounding)
Return = (1062.8-1250)/1250 = -14.97%
c) Final Spot 1/1.15 = 0.8696 USD
Option ITM
Option Payoff = 0.8696-0.8130
Receive = 3537 USD
Return = 183%
8) Assume the RUB / USD exchange rate is 0.03231 / 0.03242 and the twelve month forward points
are -325 / -317.
a) Do you think the RUB is selling at a FORWARD premium or a discount to the USD? Why?
In this case we can see from the negatives that we need to subtract the points, so the RUB is
selling at a discount (Note the USD is selling at a premium).

b) Calculate the current outright forward quote.
0.02906 / 0.02925 (19 point spread)
c) Using this rate, calculate the annualised forward premium or discount on the RUB. (I’ll
choose to solve this on the bid quote)
100
days ofnumber contract forward
360x
Spot
Spot - Forward 
100
360
360x
0.03231
0.03231 - 0.02906  10.06%- 
Chapter 5 Practice SOLUTIONS

10. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds for $.02
per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was $1.46. Assume
there are 31,250 units in a British pound option. What was Randy’s net profit on this option?

ANSWER:

Profit per unit on exercising the option = $.01
Premium paid per unit = $.02
Net profit per unit = –$.01
Net profit per option = 31,250 units × (–$.01) = –$312.50
11. Speculating with Currency Put Options. Alice Duever purchased a put option on British pounds for $.04 per
unit. The strike price was $1.80 and the spot rate at the time the pound option was exercised was
$1.59. Assume there are 31,250 units in a British pound option. What was Alice’s net profit on the option?

ANSWER:

Profit per unit on exercising the option = $.21
Premium paid per unit = $.04
Net profit per unit = $.17
Net profit for one option = 31,250 units × $.17 = $5,312.50

12. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01 per
unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82.
Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there
are 50,000 units in a Canadian dollar option. What was Mike’s net profit on the call option?

ANSWER:

Premium received per unit = $.01
Amount per unit received from selling C$ = $.76
Amount per unit paid when purchasing C$ = $.82
Net profit per unit = –$.05
Net Profit = 50,000 units × (–$.05) = –$2,500

13. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for $.03 per
unit. The strike price was $.75, and the spot rate at the time the option was exercised was $.72.
Assume Brian immediately sold off the Canadian dollars received when the option was exercised.
Also assume that there are 50,000 units in a Canadian dollar option. What was Brian’s net profit on
the put option?
ANSWER:
Premium received per unit = $.03
Amount per unit received from selling C$ = $.72
Amount per unit paid for C$ = $.75
Net profit per unit = $0
17. Price Movements of Currency Futures. Assume that on November 1, the spot rate of the British pound was
$1.58 and the price on a December futures contract was $1.59. Assume that the pound depreciated during
November so that by November 30 it was worth $1.51.

a. What do you think happened to the futures price over the month of November? Why?
ANSWER: The December futures price would have decreased, because it reflects expectations of the future
spot rate as of the settlement date. If the existing spot rate is $1.51, the spot rate expected on the December
futures settlement date is likely to be near $1.51 as well.

b. If you had known that this would occur, would you have purchased or sold a December futures contract in
pounds on November 1? Explain.

ANSWER: You would have sold futures at the existing futures price of $1.59. Then as the spot rate of the
pound declined, the futures price would decline and you could close out your futures position by purchasing a
futures contract at a lower price. Alternatively, you could wait until the settlement date, purchase the pounds in
the spot market, and fulfil the futures obligation by delivering pounds at the price of $1.59 per pound.

18. Speculating with Currency Futures. Assume that a March futures contract on Mexican pesos was available in
January for $.09 per unit. Also assume that forward contracts were available for the same settlement date at a
price of $.092 per peso. How could speculators capitalize on this situation, assuming zero transaction
costs? How would such speculative activity affect the difference between the forward contract price and the
futures price?

ANSWER: Speculators could purchase peso futures for $.09 per unit, and simultaneously sell pesos forward at
$.092 per unit. When the pesos are received (as a result of the futures position) on the settlement date, the
speculators would sell the pesos to fulfil their forward contract obligation. This strategy results in a $.002 per
unit profit.

As many speculators capitalize on the strategy described above, they would place upward pressure on futures
prices and downward pressure on forward prices. Thus, the difference between the forward contract price and
futures price would be reduced or eliminated.
22. Speculating with Currency Put Options. Bulldog, Inc., has sold Australian dollar put options at a
premium of $.01 per unit, and an exercise price of $.76 per unit. It has forecasted the Australian
dollar’s lowest level over the period of concern as shown in the following table. Determine the net
profit (or loss) per unit to Bulldog, Inc., if each level occurs and the put options are exercised at that
time.
ANSWER:

Possible Value Net Profit (Loss) to
of Australian Dollar Bulldog, Inc. if Value Occurs
$.72 –$.03
.73 –.02
.74 –.01
.75 .00
.76 .01
25. Estimating Profits From Currency Futures and Options. One year ago, you sold a put option
on 100,000 euros with an expiration date of one year. You received a premium on the put option of $.04 per
unit. The exercise price was $1.22. Assume that one year ago, the spot rate of the euro was $1.20, the one-year
forward rate exhibited a discount of 2%, and the one-year futures price was the same as the one-year forward
rate. From one year ago to today, the euro depreciated against the dollar by 4 percent. Today the put option will
be exercised (if it is feasible for the buyer to do so).

a. Determine the total dollar amount of your profit or loss from your position in the put option.
b. Now assume that instead of taking a position in the put option one year ago, you sold a futures
contract on 100,000 euros with a settlement date of one year. Determine the total dollar amount of your profit or
loss.
ANSWER:
a. The spot rate depreciated from $1.20 to $1.152.
The loss on the put option per unit is $1.152 - $1.22 + $.04 = -$.028. Total loss = $.028 x 100,000 = $2,800.
b. The forward rate one year ago was equal to:
$1.20 x (1 - .02) = $1.176. So the futures rate is $1.176. The gain per unit is $1.176 - $1.152 = $.024 and the
total gain is $.024 x 100,000 = $2,400.
39. Uncertainty and Option Premiums. This morning, a Canadian dollar call option contract has a
$.71 strike price, a premium of $.02, and expiration date of one month from now. This afternoon,
news about international economic conditions increased the level of uncertainty surrounding the
Canadian dollar. However, the spot rate of the Canadian dollar was still $.71. Would the premium of
the call option contract be higher than, lower than, or equal to $.02 this afternoon? Explain.
ANSWER: The premium will be higher than $.02. The call option premium is positively related to
expected volatility and when uncertainty surrounding the exchange rate increases, the expected
volatility increases.