Question
Consider a one period binomial model of a currency option on the dollar. The current (date t = 0) spot exchange rate is S0 =
Consider a one period binomial model of a currency option on the dollar. The current (date t = 0) spot exchange rate is S0 = 90 pence per dollar. The spot rate at the end of the period will be either Su = 100 pence or Sd = 64 pence. The UK risk-free interest rate over the period is rs = 1/3, (33.33333%), and the US risk-free rate of interest is rd = 1/2, (50%). There is a call option with a strike price of K = 85 pence. There is also a forward contract with a price of F = 80 pence per dollar.
The exposure of the call option to changes in the exchange rate is given by = CuCd SuSd where Cu is the value of the call in the up state and Cd is its value in the down state. Calculate the exposure of the call. Explain what is meant by exposure.
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