Question 3 Sven notes one day that the premium on a 150000 E

Question 3, Sven notes one day that the premium on a 150,000 Euro June Call Option with strike price of $1.21 is $.02 per Euro. In addition, there\'s a bank in Germany offering a June Forward contract for $1.24 per Euro, and a bank in NY is willing to make him a loan (in dollars) for 25%. Show how Sven can make a killing with very little effort. What\'s the minimum he\'ll earn for each 150,000 Call Option contract he purchases? How and when will he make more than this minimum amount? Explain.

Solution

This seems like an risk less trade.

SInce the strike price is $1.21 and forward contract price is $1.24, sven can lock a profit of $0.03 by going long on call option and short on forward. He can get into this trade by paying a premium of $0.02.

This will result into $0.01 per stock.

So, overall minimum profit would be 150,000 * $0.01 = $1,500

However, to buy call options, Sven will take loan on 25%.Hence he will also pay some interest.

Interest would be

=150,000 * $0.02 * 0.25 = $750

Overall minimum profit would be

=1500-750 = $750

Sven can make more profit if he can get short on forward contract with higher offer price. With everything else same, Sven can ock in bigger profitby buying call option and shorting forward.