Suppose that the volatilities used to price a 6-month currency option are as in Table 16.2. Assume that the domestic and foreign risk-free rates are 5% per annum and the current exchange rate is 1.00. Consider a bull spread that consists of a long position in a 6-month call option with strike price 1.05 and a short position in a 6-month call option with a strike price 1.10.

(a) What is the value of the spread?

(b) What single volatility if used for both options gives the correct value of the bull spread? (Use the DerivaGem Application Builder in conjunction with Goal Seek or Solver.)

(c) Does your answer support the assertion at the beginning of the chapter that the correct volatility to use when pricing exotic options can be counterintuitive?

(d) Does the IVF model give the correct price for the bull spread?

AppendixLO1