Confusing asset allocation question from past exam

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passcfa2016

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We are told that Aron is considering tactical allocation and has forecasts that the GBP will appreciate by 5% against the USD over the next six months. The current USD/GBP rate is 1.60 (1 GBP = 1.60 USD). Aron is considering the following six-month European option positions with the primary objective of increasing his GBP exposure in line with his forecast, and a secondary objective of minimizing the initial cash outlay:
Trade 1: Buy call with 1.68 strike & Sell call with 1.72 strike
Trade 2: Buy call with 1.60 strike & Sell call with 1.68 strike
Trade 3: Buy call with 1.60 strike & Sell call with 1.72 strike
Which trade will most likely satisfy Aron’s objectives at expiration??????????????????????? and why
 
I think it would be the Trade 3?
my reasoning -> the 6 month expected price = 1.60 * 1.05 = 1.68 USD / GBP.
now he needs to minimize initial cash outlay. So buy a call option far out the money. So 1.60 (current USD/GBP rate) makes sense.
Sell Call with 1.72 Strike … will allow him to increase exposure? (This part the how of it I am not sure).
But I went with the 1.68 needing to lie between the buy and call strike prices.
 
cpk123 wrote:
I think it would be the Trade 3?
my reasoning -> the 6 month expected price = 1.60 * 1.05 = 1.68 USD / GBP.
now he needs to minimize initial cash outlay. So buy a call option far out the money. So 1.60 (current USD/GBP rate) makes sense.
Sell Call with 1.72 Strike … will allow him to increase exposure? (This part the how of it I am not sure).
But I went with the 1.68 needing to lie between the buy and call strike prices.
Click to expand...
Well, isn’t it that the 1.60 call option is more expensive than the 1.68 call option? How about trade 1, especially when he expects GBP to rise by 5% in 6 months?
 
when the price of GBP is 1.68 wouldn’t 1.60 be far out the money? i think at the money call would be 1.68 - that would be more expensive. ( this is what I think, could be wrong).
 
I’d go with Trade 2, reasoning below:
1. GBP is expected to rise 5% i.e. from $1.6 to $1.68, hence Aron would buy a $1.60 strike call in order to be in the money at expiration. Going long a $1.68 call will not give him any payoff.
2. Since Aron wishes to minimise his initial cash outlay, he would go short the $1.68 call. By doing so he does not give up any upside (since he expects GBP to increase to $1.68). Also, because the lower strike 1.68 call is more expensive relative to the 1.72 strike, shorting the 1.68 strike better offsets his 1.60 long call position to minimise outlay
 
oz001 wrote:
I’d go with Trade 2, reasoning below:
1. GBP is expected to rise 5% i.e. from $1.6 to $1.68, hence Aron would buy a $1.60 strike call in order to be in the money at expiration. Going long a $1.68 call will not give him any payoff.
2. Since Aron wishes to minimise his initial cash outlay, he would go short the $1.68 call. By doing so he does not give up any upside (since he expects GBP to increase to $1.68). Also, because the lower strike 1.68 call is more expensive relative to the 1.72 strike, shorting the 1.68 strike better offsets his 1.60 long call position to minimise outlay
Click to expand...
This is my reasoning also.
 
The correct answer is Trade 2. I once saw a similar question from Analystninja and queried it; but this question is from CFA level 3 2015 actual exam - question 9 C.

The reason being that Trade 2 would be the most likely to satisfy the objectives. By buying a call struck at the current spot rate (1.60), Aron will benefit if GBP appreciates per his outlook. Selling the higher strike price out-of-the-money call at 1.68 (equal to his 5% appreciation expectation) would provide some premium income to reduce the cost of the trade, while not reducing his potential appreciation below 5%.
 
Thanks CPK and OZ; and everyone else.Yes the correct answer is between trade 2 or 3; trade 1 is completely out as it wont benefit from the upside. However trade 2 is better than 3 as the premium is higher on selling at 1.68. Making trade 2 the correct final answer.
 
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