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1. Let the continuously compounded 6-month USD interest rate be 3% p.a., let the analogous JPY interest rate be 1% p.a., let the exchange rate be ¥98 >$, and assume that the volatility of the continuously compounded annualized rate of appreciation of the yen relative to the dollar is 13%. Use the Garman- Kolhagen option pricing model to determine the yen price of a 6-month European dollar call option with a strike price of ¥100 >$. How does your an- swer change if the volatility were 16% p.a.?
2. With the same variables as in Problem 1, use put-call parity to determine the yen price of the corresponding dollar put option with the same maturity and same strike price.
3. Suppose a trader sells a call option on £500,000 with a delta of 0.35 and buys another call option on £1,000,000 with different parameters whose delta is 0.55. What is his net exposure to small movements in the exchange rate? How could he cover this position?
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