Question: Consider a four-month call option on the British pound. Suppose that the current exchange rate is usd/gbp 1.6, the exercise price is usd/gbp 1.6, the

Consider a four-month call option on the British pound. Suppose that the current exchange rate is usd/gbp 1.6, the exercise price is usd/gbp 1.6, the risk free rate on the usd is 8 percent p.a., the risk free rate on gbp is 11 percent p.a., and the volatility of the spot rate (and the forward rate) is 10 percent. Using the results in Teknote ??, translate the volatility into an up and down factor (u and d). Then solve the following problems:

(a) What is the value that you would be willing to pay for this American call option if you used the one-period binomial approach to value it?

(b) What would you be willing to pay for this option if the volatility were 14.1 percent?

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