Option Pricing and PPP Deviation

¶ … deviations from purchasing power parity for countries' competitive positions in the world markets? Per a Wisconsin University study, there are two major effects. The first is a "real barriers" effect and the other is a sticky-consumer-price issue. The first of those two can cause deadweight welfare losses. However, that could be counteracted by fixed exchange rates. However, this can be flummoxed by a lack of pass-through along the entire market due to breakdowns in passing along the price fixation.

Also important to keep in mind is that deviations can be both regional within one country or international between a number of countries. However, fixed exchange rates are often eschewed in favor of a floating one as even though there will be more efficiency in some ways, new issues will be created due to the artificial influence exerted on the market. A country deviating from its PPP levels and speclaizations can upset the proverbial apple cart, so to speak.

For example, the ethanol-producing activities of the United States had the effect of raising prices for corn even for those that were not in the gas-producing business like people seeking and dealing corn tortillas and other products in Mexico. When the market is shifted in such a seismic way, the ripples are easy to see early and often (Engel & Rogers, 2001). Assume the spot Swiss franc is $0.7000 and the six-month forward rate is $0.6950.

What is the minimum price that a six-month American call option with a striking price of $0.6800 should sell for in a rational market? Assume the annualized six-month Eurodollar rate is 3.5%. Use formulas to calculate the answers and clearly label your analysis. In 200- 300 words explain your answer and your rationale There are two main numbers that should be pointed to. First, the six-month rate shows the value of the franc will fall, albeit by only 0.005. At the same time, the Eurodollar rate is 3.5% over that same period.

The striking price of 0.6800 is quite a deal as it would, at least at first, yield a profit if 0.2 per franc. At the same time, the Eurodollar rate would increase the value of the currency at a clip that more than cancels out the loss in spot price that is projected over the next six months. That Eurodollar rate alone, even with the loss of value (if that holds), gives a rise up to nearly 0.72 in that six months. Someone could grab the option of 0.68, allow the interest.