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Interest Rate Parity, Exercise Price, ARM & FRM

10.[5] You can buy or sell the £ spot at $1.60 to the pound. You can buy or sell the pound 1 year forward at $1.62 to the pound. If U.S. annual interest rates are 4%, what must be the one year British interest rate if interest rate parity holds?.

11.[4] A stock has a spot price of $35. Its May options are about to expire. One of its puts is worth $5 and one of its calls is worth $5. The exercise price of the put must be ___A__ and the exercise price of the call must be ___B__. (please show work for A & B)

12.[2] Why do mortgage lenders prefer ARMs while many borrowers prefer fixed rate mortgages, ceteris paribus?

Solution Preview

10. Using Interest rate parity formula...

Forward rate = Spot rate * ( 1+ Interest rate of Overseas Country) / (1 + Interest rate of domestic Country)

Then,

1.62 = 1.60 *(1+4%)/(1+r)
or
1 + r = 1.60 *(1+4%)/1.62
or
1+r = 1.664/1.62
or
1+r = 1.02716
or
r = 1.02716 - 1 = 0.02716 = ...

Solution Summary

The solution provide clear example to compute interest rate for domestic/ international currency with given scenario. In another example it will compute exercise price for both call & put option and thirdly it explains, why lender prefer ARM instead of FRM.

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