Question

Suppose you are trading currency options at the Chicago Mercantile Exchange on September 28, 2002. The current US-German exchange rate is .71 dollars per mark. The German interest rate is 3.5% and the U.S. interest rate is 5.25%. Suppose a call which gives the holder the right to buy marks at a rate of .70 dollars per mark is selling for .0163 per mark and a put which gives the holder the right to sell marks at a rate of .70 dollars per mark is selling for .0102 per mark. Each option contract is for 125,000 marks. Assume both the put and the call are European and they both expire on November 17, 2002.   What arbitrage opportunities are available? Show the cash flows associated with your arbitrage strategy

Answer 1

Arbitraage Oportunity : Take Maximum Investment to USA inplace of German to get additional Intrest of 1.75% (5.25%-3.5%)

With this scenario Put Option is more benificial compare to call Option.

Put Option have + 219.14 Marks cash Flow wher cll option -593 cash Flow as per below calculation

		German	USA
		Mark	USD
	Conversion	1	0.71
	Interest rate	3.50%	5.25%
				Premium
	Call option	1	0.7	0.0163	0.7163
	Put option	1	0.7	0.0102	0.7102
	Marks	Current Value	Trading value	Net Benefit	Interest Diff	Net Benefit
Call Option	125000	88750	89537.5	-787.5	194.140625	-593.359
Put Option	125000	88750	88775	25	194.140625	219.1406