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CT2 / September 2013 / Question 1

Discussion in 'CB1' started by Leigh Costanza, Mar 25, 2020.

  1. Hi there,
    I was wondering if somebody could explain the solution to the question in the thread title, please?
    It could be that I'm reading the question wrong...
    If the trader expects to receive an amount of Euros (say €100), suppose they buy an option to trade at the current price, say $1 for €1.
    If the Euro strengthens, then that €100 is going to buy more than $100 anyway, which is a win for the trader, so no need to use the option.
    If the Euro weakens, then that €100 is going to buy fewer than $100. At this point, exercising the option would then make sure they could still get the $100 and not lose out.
    Hence I get to the answer D, but the solution in the revision booklets says C.

    I did try reading the question the other way round:
    The trader expects to receive $100s worth of Euros, and buys an option to trade at the current price, say $1 for €1.
    If the Euro strengthens, then they'll receive fewer than €100, so they would not look to use their option, as under the option price they'd end up with less than $100.
    If the Euro weakens, then they'll receive more than €100. The current rates would mean that this was still worth $100, but if they ued their option they could convert this into more than $100, which is a win.

    Hence I get to the answer D again.

    Could somebody please explain what I'm doing wrong? I may have misunderstood what it means for a currency to weaken, but as I understand it, if currency A weakens against currency B, then you need more of A to be worth the same B. I think that's what I've done above, but any help would be appreciated.

    Not sure how to get to C :(
     
  2. Michal Piatra

    Michal Piatra Keen member

    Hi Leigh,
    I took a look at it and I think you just misunderstood the question/answers.
    The question is asking why he might use option rather than future.
    In my opinion, you analysis is correct. However, if the euro strengthens with option he has the choice of not excercising.
    If he bought future contract he would have to "excercise" it and make a loss on it.
    Hence, the option will provide scope for an upside if the Euro strengthens. (Answer C)
    I hope I understand it correctly :)
     
    Lynn Birchall likes this.

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