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if the question does not give the spot rate on the date of transaction, how do we know whether to exercise the option or not ?
example – MJY case study
the answer key says “assuming option exercised”Showing what happens if the option is exercised is showing what the worst possible outcome is. (If the spot rate is more in our favour then we would not exercise and the outcome would be better).
The examiners answer says this, and given that this is a high-level exam, this is what you would be expected to discuss.
(I assume that you have watched my free lectures on foreign exchange options?)
Then why is it that for Kenduri Co question, the answer was that option was not exercised.
Both these case studies did not mention the spot rate on the date of transaction. So how to decide whether option should be exercised or not?Well, sir told that we have to explain the situation, we don’t need to calculate.
nehaelsa: Read my reply and the examiners answer carefully.
We do not know what the spot rate will be and therefore we do not know whether or not the option will be exercised.
However we can calculate what the spot rate would need to be for the option to be worth exercising and therefore what the worst rate is limited to, which is the whole point of using options.
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