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Hi. I would like to know whether we deal with basic risk on currency option. As per P4 june 2014 section A, the exercise price is taken as the effective rate although the option expires 2 month after.
Be careful – it is not called ‘basic risk’. It is called ‘basis risk’. 🙂
I assume that you are asking about part a of question 1 in the June 2014 exam?
If you are, then best is to watch the free lectures where I work through the whole of this question.
You can find it linked from “P4 Revision and Past Questions” on the main P4 page of this website.Ive watch the video. I would like to know why basis risk has not been taken into consideration. Im a bit confused. There is 2 month unexpired basis risk.
The alternative that the examiner shows in italics in his answer is the better approach (and the one I use in the lecture).
He has taken the basis risk into consideration (that is what the 4/6 is) and has calculated the lock-in rate. (The free lecture on lock-in rates might help you with this).
He has taken basis risk into consideration only on the future.
I want to know why this has not been taken into consideration for the option.But basis risk is never of any relevance at all with exchange rate options!! The option is the right to convert at a fixed rate i.e the strike price.
The basis risk is the the difference between the futures price and the spot rate – foreign exchange options have nothing to do with futures.(It is only relevant when dealing with interest rate options, but only because those options are options to deal in interest rate futures.)
I really do suggest that you watch the free lectures again – they deal with all of this in detail, with examples.
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