1a) For European options, what is the effect of an increase in the spot rate?

Decrease the value of calls and puts ceteris paribus

Increase the value of calls and puts ceteris paribus

Decrease the value of calls, increase the value of puts ceteris paribus

Increase the value of calls, decrease the value of puts ceteris paribus

1b) An American currency dealer has good credit and can borrow either $1,000,000 or 800,000 for one year. The one-year interest rate is i_$ = 2% in the U.S. and i = 6% in the euro zone, respectively. The spot exchange rate is $1.25 = 1.00 and the one-year forward exchange rate is $1.20 = 1.00. Show how you can realize a certain dollar profit via covered interest arbitrage.

Borrow $1,000,000 at 2%; trade $1,000,000 for 800,000 at the spot rate; invest euros at i = 6%; translate euro proceeds back to dollars at the forward rate of $1.20 = 1.00. Gross proceeds will be $1,017,600.

Borrow $1,000,000 at 2%; trade $1,000,000 for 800,000 at the spot rate; invest euros at i = 6%; translate euro proceeds back to dollars at the forward rate of $1.20 = 1.00. Net profit will be $17,600.

Borrow 800,000 at i = 6%; translate euros to dollars at the spot rate, invest dollars in the U.S. at i_$ = 2% for one year; translate dollars back to 850,000 at the forward rate of $1.20 = 1.00. Net profit will be 2,000.

Borrow 800,000 at i = 6%; translate euros to dollars at the spot rate, invest dollars in the U.S. at i_$ = 2% for one year; translate dollars back to 848,000 at the forward rate of $1.20 = 1.00. Net profit will be $2,400.