Question: Consider a call option on the British pound (BP) which represents the right to purchase 1,000 at the strike price of $1.45per . The option

Consider a call option on the British pound (BP) which represents the right to purchase 1,000 at the strike price of $1.45per . The option will expire in one year. The current spot rate is $1.45per (at the strike). In the future, the spot rate may become $1.40 or $1.50 per . The annual risk-free interest rate is 2.0% in the US and 2.5% in the UK. A pure-discount British bond, that will pay 1,000 on the maturity date, is selling for 968.15now.

If you buy a British bond, how many calls do you have to buy or sell to construct a risk-free hedge portfolio? What is the future dollar value of the hedge portfolio?

(2) What is the fair price of this call option?

(3) Suppose the call is trading for $20 per contract. Show how you can realize arbitrage profit and determine the profit. Assume you buy or sell one unit of British bond.

4)Show how you can construct a risk-free hedge portfolio using a U.K. bond and the put options on . What is the future dollar value of the hedge portfolio?

5) Determine the fair price of this put option using the arbitrage argument.

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