Suppose you are a speculator and you can buy or sell a 12-month call option on euros with a strike price of 1.22/€, and a call premium of $0.03/€. Nominal interest rates are 3% per annum in the U.S. and 2% per annum in Europe.  Inflation in the U.S. and Europe is expected at 2% and 0.5% respectively.  The current spot rate is S($/€)=1.1785. Euro options are for 10,000 euros.

Graph the cash flow schedule from the perspective of the buyer and the seller.

If your currency expectations are based on the International Fisher effect, would you buy or sell the option?  What is your expected speculative profit?

If your currency expectations are based strictly on relative PPP, would you buy or sell the option? What is your expected speculative profit?