option Pricing

devinarastogi84
Good Student
Posts: 22
Joined: Thu Apr 17, 2014 9:40 pm

option Pricing

Postby devinarastogi84 » Mon Apr 28, 2014 5:29 pm

Question: If the current USD/AUD rate is 0.6650 (1 AUD=0.6650USD) & the risk-free rates for the USD & AUD are 1.0% & 4.5% respectively, what is the lower bound of a 5-month European put option on the AUD with a strike price of 0.6880?
In the above question , how do we understand that Formula (Ke^-rT - Se^-rf T) should be used. As per formula for Eruopean put option it should be (Ke^-rt -S) , Also how do we determine that r used with strike will be r% given as 1% for USD not for AUD 4.5% while we are calculating it for AUD.

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

option Pricing

Postby edupristine » Tue Apr 29, 2014 6:18 am

Whenever we have questions on currencies, we have concept of domestic interest rate and foreign interest rate. Lets say if you convert USD to AUD, for that you borrowed USD at domestic rate. Now you have AUD with you which you can lend at foreign rate (rf). So, with strike you always use domestic rate and with S you always use the earning (dividend yield in case its a stock and foreign interest rate if it is a currency). Let me know if it makes sense.


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