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When deciding whether to exercise the option or not , we compare the spot rate of transaction date with the exercise price which are $1.1456/ euro and $1.1420/ euro respectively.
here the option would be exercised as it gives a higher receipt. ( or at least this is what i understand).
but when i looked at the answer, it says that the option is not exercised.
can you please explain why?In future please do say which exam the question is from. I cannot remember the name of every question that has ever been set 🙂
You are quoting a spot rate of $1.1456. I can only assume that you are getting this from the forward rate, but just because there is a forward rate of 0.8729, it certainly does not mean that this will be the future spot rate – it is unlikely that will be the case and we cannot assume that it will be.
The examiners answer does not say that the option will not be exercised. It says that the forward and futures markets both suggest that the dollar is expected to strengthen. If it does strengthen then is then less likely that the option will be exercised.
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