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An investor wants to hedge against currency price movements that could offset the yield s/he expects to earn on a lending spread created by simultaneous

An investor wants to hedge against currency price movements that could offset the yield s/he expects to earn on a lending spread created by simultaneous long and short postions in bonds. a. A currency worth $0.80 that could increase in value by 2% per period over the next two months. The domestic and foreign risk-free interest rates are 6% and 8%, respectively. If the strike price is also $0.80, then use the binomial pricing theorem to price both the call and put options. Verify your answer using the put-call parity relationship. b. EXPLAIN whether the investor should act as a borrower or lender in the domestic country AND, based upon the call & put option deltas at option A, whether the expected exchange rate movement (dollar relative to the foreign currency) would likely increase or decrease the profitability of the yield spread. c. The current exchange rate for a currency is 0.52, the volatility is 12%, and the domestic and foreign risk-free rate are 4% and 8% per annum respectively. If the strike price on an 8-month option is 0.50, use Black-Scholes to price the call and put options. Use put-call parity to verify your answer. d. For part c, EXPLAIN whether the investor should act as a borrower or lender in the domestic country AND, based upon the call & put option deltas at option A, provide a logical explanation for the value of gamma and why the investor should care.

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