Consider a one period binomial model of a currency option on the dollar. The current (date t = 0) spot exchange rate is S0 = 75 pence per dollar. The spot rate at the end of the period will be either Su = 100 pence or Sd = 60 pence. The UK risk-free interest rate over the period is rs = 1/3 (33.3333%) and the US risk-free rate of interest is rd = 1/4 (25%). There is a call option with a strike price of K = 68 pence and a forward contract with a price of F = 80 pence. Show how to use the forward contract and the UK money market to replicate the payoffs to the call option and hence, find the price of the call option.
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25\), \(u = 1.33\), and \(d = 0.8\). Show more…
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