1. Assume that you can borrow EUR 1,000,000 or USD 1,000,000. Assume that you use Purchasing Power Parity (PPP) to forecast exchange rates. You expect that inflation in France the next year will be -1.0%, and inflation in the US will be +2%. Assume that you are considering the purchase of five one-year euro call options from PHLX with a strike price of $1.08/. The premium is 0.5 cents per . Today the spot rate of the euro is $1.06/. The one-year forward rate is $1.07/.

a. Based on your PPP analysis, what will be your expected spot exchange of $/ in one year?

b. Graph the call option cash flow schedule at maturity. Mark clearly where will be options break-even point.

c. Determine your expected profit (or loss) if the euro appreciates to your expected future spot rate.

d. Determine your expected profit (or loss) if the euro appreciates to the forward rate.

(Note: One PHLX euro option contract covers 10,000. For simplicity, ignore the time value of money)