Foreign Exchange: A Practical Guide to the FX Markets

By Tim Weithers
Copyright © 2006 by Tim Weithers

Answers to the
Chapter Exercises

CHAPTER 2 Markets Exercises

1. If you need to purchase 2,000 ounces of platinum, you can buy it
where the marketmaker is willing to sell it—at USD 976 per ounce.
You would respond to the market quote with, “I would like to buy
2,000 ounces of platinum at a spot price of USD 976 please,” or, more
simply, “Mine, 2,000 (ounces) at 976.”
In two business days, you will wire USD 1,952,000 to the dealer
and receive delivery (in whatever manner has been arranged for this) of
2,000 ounces of platinum.
2. A marketmaker in spot platinum would want to know (among other
things): last trade price, market direction (based on fundamental analy-
sis and/or technical analysis), their position, order flow, news coming
out, and other relevant information that might move the spot price of
platinum.

CHAPTER 3 Interest Rate Exercises

1. The interest on USD 10,000,000 for 3 months (90 days) at r = 4.80%
(where this is a simple actual/360 rate):
USD 10,000,000 × (.0480) × (90/360) = USD 120,000
2. The Euros you would receive if you deposited 40 million Euros for 12
years at a quarterly compounded rate of r = 6.00% (treating each quar-
ter as exactly 1/4 of a year):
EUR 40,000,000 × [1 + {(.06)/4}]12×4
= EUR 40,000,000 × [1.015]48
= EUR 81,739,131.56
which should make sense if you know the Rule of 72, which says your
money should approximately double when the time frame, t (here, 12
years), and the interest rate, r (here, 6.00%), if multiplied together, gives

273
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274 ANSWERS TO THE CHAPTER EXERCISES

a number around 72; more on this in the answer to Question 4 of this

section.
3. The amount of Pounds Sterling today that are equal to 20,000,000
Pounds in 200 days if the relevant U.K. interest rate (quoted annually)
is 8.20% depends on how you discount: Either
GBP 20,000,000/[1 + (.0820)(200/365)] = GBP 19,140,010.48
or
GBP 20,000,000 × [1 – (.0820)(200/365)] = GBP 19,101,369.86
The former would be the more likely calculation for market pur-
poses (because that number of Pounds, deposited at r = 8.20% with
simple interest would grow to GBP 20,000,000 in 200 days), although
U.S. Treasury Bills and commercial paper typically use the latter con-
vention. (Recall: GBP interest rate calculations typically assume that a
year consists of 365 days.)
4. How long will it take for your money to double? More concretely, if
you are quoted a rate of interest of 6.00% (compounded annually),
how long will it take for your money today (PV) to double (i.e., so that
FV = 2 × PV)? This answer explains the Rule of 72, mentioned earlier.
This is most easily shown using the continuous interest convention: FV
= PV ert. In effect, it asks, “What is that time frame, t*, over which your
money (PV) will double (turn into 2 × PV) with a given interest rate?”
Writing this out, FV = 2 PV = PV ert*. We can cancel the PVs (as the ini-
tial amount of money does not matter for solving this math problem),
and we get 2 = ert*; we can then take the natural logarithm (ln) of both
sides: ln(2) = .69314718 = ln(ert*) = rt*. Rounding off the left-hand side
to .70, we get .70 = rt* . . . which says, for example, that, with continu-
ous interest, if r = 5%, then it will take around t* = 14 years for your
money to double, whereas, if interest rates are 7%, it will only take
around t* = 10 years for your money to double. We said that not many
financial institutions give continuous interest, so it may take a little
longer; that fact, in conjunction with the observation that 72 seems nicely
divisible by a larger number of integers, gives us the Rule of ‘72’: One’s
money should approximately double depending on the rate of interest re-
ceived according to the following general rule of thumb: r × t* = .72.

CHAPTER 5 Spot Exercise #1

1. The name of the exchange rate quoting convention between U.S. Dol-
lars and Canadian Dollars if we quote USD|CAD: a European quote—
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Answers to the Chapter Exercises 275

even though neither currency has anything to do with Europe. [If, on

the other hand, someone wanted this currency pair quoted CAD|USD,
it would be referred to as an American quote.]
2. If USD|CAD is quoted S = 1.2000, it means that USD 1 (1 U.S. Dollar)
will trade for (e.g., can be bought or sold for) CAD 1.2000 (1.20
Canadian Dollars).
3. If USD|CAD S = 1.2000, then CAD|USD S = (1/1.2000) = .83333333
. . . (though we usually only quote spot prices out four decimal places,
so, CAD|USD S = .8333).
4. The name of the foreign exchange rate quoting convention between
Australian Dollars and U.S. Dollars (“Aussie”) if we quote AUD|USD
(as we do in the interbank market) is an American quote (because it re-
flects how many American (U.S.) Dollars per one Australian Dollar.
5. If AUD|USD S = .7500, then one Australian Dollar will trade for .75
U.S. Dollars.

Spot Exercise #2
One might guess that the exchange rate between Japanese Yen and Swiss
Francs (knowing that Yen are small) would be quoted CHF|JPY or Swiss-
Yen or Japanese Yen per one Swiss Franc (as, indeed, it typically is).
One might further guess that the exchange rate between Euros and
Swiss Francs is quoted EUR|CHF or Euro-Swiss or Swiss Francs per one
Euro.

Spot Exercise #3
1. The price of a Dollar could fall against the Swiss Franc and rise against
the Japanese Yen; this would imply USD|CHF went down (the U.S.
Dollar weakened against the Swiss Franc) and USD|JPY went up (the
U.S. Dollar strengthened against the Japanese Yen). If this is the case,
there is no doubt that the Swiss Franc just strengthened against the
Japanese Yen (i.e., that CHF|JPY went up).
2. Can you buy U.S. Dollars with Pounds Sterling? Yes, and no, and yes!
Of course you can buy Dollars with British Pounds, but, in the inter-
bank market, a professional dealer would never say that; since the
quoting convention between U.S. Dollars and Great Britain Pounds in
the marketplace involves GBP|USD (i.e., Dollars per Pound), what you
trade (that is, the underlying asset) is Pounds. If you want to buy Dol-
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276 ANSWERS TO THE CHAPTER EXERCISES

lars with Pounds, one would say, “I sell Sterling-Dollar,” or “I sell Ca-
ble.” Confusing, isn’t it?
If you wanted to sell Japanese Yen in exchange for Dollars, what
would you say?

Spot Exercise #4
Complete the following table of foreign exchange (cross) rates (bold num-
bers given):

USD EUR JPY GBP CHF

USD — 1.2500 .009091 2.0945 .8727
EUR .8000 — .007273 1.6756 .6982
JPY 110.00 137.50 — 230.40 96.00
GBP .4774 .5968 .004340 — .4167
CHF 1.1458 1.4323 .010417 2.4000 —
(Hint: Look back at Figure 1.9. To get oriented, start with USD and
JPY.) Start by “inverting” all the quotes you are given (e.g., EUR|USD
= 1.2500 so USD|EUR = (1/1.2500) = .8000). Then start looking for
other pairs; knowing USD|EUR = .8000 and USD|JPY = 110.00, then
EUR|JPY = 110.00/.8000 = 137.50. Similarly, knowing it takes 2.40
CHF per GBP 1 and 96 JPY per CHF 1, then it should take 230.40
JPY per GBP 1. (Answers are rounded to two, four, or six decimal
places.)

Spot Triangular Arbitrage Exercises #5

1. Given the following spot prices:
USD|JPY 110.00
USD|CHF 1.2500
CHF|JPY 85.00
triangular arbitrage starts by identifying where one currency pair is
(i.e., too high or too low) in relation to the other two. Given the first
quote USD 1 = JPY 110.00 and the second quote USD 1 = CHF
1.2500, then the exchange rate between CHF and JPY should follow
from CHF 1.2500 = JPY 110.00 or, to put it in market terms,
CHF|JPY should = 88.00. If CHF|JPY S = 85.00 in the market, it is too
low (relative to where it should be trading). More precisely, the price
of one Swiss Franc is lower (in terms of Japanese Yen) than it should
be; one would want to BUY CHF and SELL JPY (as a single trade). If
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Answers to the Chapter Exercises 277

you start with CHF, you don’t want to sell them for JPY, so sell them
for USD, then sell the USD for JPY, and finally, sell the JPY for CHF.
The cash flows would look like this:
Start: CHF 40,000,000 to USD 32,000,000 to JPY 3,520,000,000
back to CHF 41,411,764.71. Your profit in Swiss Francs is CHF
1,411,764.71 (or in percentage terms, you make 3.529412%, which,
coincidentally, is exactly
[.8800/.8500 – 1].
See Figure A.1.

Begin: CHF 40,000,000

End: CHF 41,411,764.71

85.00 1.2500

JPY 3,520,000,000 USD 32,000,000

x 110.00
FIGURE A.1 Triangular Arbitrage

2. Given the following spot quotes:

EUR|GBP .6850
GBP|USD 1.8420
EUR|USD 1.2500
a triangular arbitrage starting with EUR 100,000,000 and realizing
your profit in USD can be done two ways. One could simply do a reg-
ular triangular arbitrage starting with EUR and ending with EUR and
then converting your EUR profit back into Dollars, or you can “take”
your profit along the way.
Let’s try to consider the latter: First, looking at the first two
quotes, EUR|USD should = 1.26177 (so the market price is too low;
therefore, BUY EUR = SELL USD). Since we start with Euro, this
would mean we go from EUR to GBP to USD to EUR. Starting with
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278 ANSWERS TO THE CHAPTER EXERCISES

Begin: EUR 100,000,000

End: EUR 100,000,000

x .6850 x 1.2500

GBP 68,500,000 USD 126,177,000

x 1.8420 minus
USD 1,177,000 (USD Profit)
= USD 125,000,000

FIGURE A.2 Triangular Arbitrage

EUR 100,000,000 gives GBP 68,500,000, which subsequently gives

USD 126,177,000.
At this stage, you might recognize that with EUR|USD S = 1.2500,
all you should have to give up is USD 125,000,000 to get EUR
100,000,000. This would mean that you could take your profit in
USD. That amount is USD 1,177,000.
If instead one had gone through the entire triangular arbitrage:
EUR to GBP to USD to EUR, the resultant Euro position would have
been EUR 100,941,600.00, which, net of the original EUR
100,000,000, gives a profit (in Euro) of EUR 941,600, which, trans-
lated at EUR|USD S = 1.2500 gives (as expected) USD 1,177,000. Re-
ality check: 1.26177/1.2500 – 1 = .009416%, which is obvious enough
in Euro—but that’s also the ratio of the USD profit to the magnitude of
the USD trade: USD 1,177,000/125,000,000. (See Figure A.2.)

CHAPTER 6 Forward Exercise #1

If a stock is trading at S = 100.00, interest rates are r = 4.00 percent, we are
thinking about a one-year time frame (t = 1), and, over the course of the
year, this stock will pay a quarterly dividend of Div = 0.25, where would
the one-year forward price be quoted?
Using our forward relationship:

F = S + Srt – Div
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Answers to the Chapter Exercises 279

we would have

F = 100 + 100(.04)(1) – (.25) × 4 = 103

Forward Exercise #2
If USD|JPY is trading in the spot market at S = 110.00, Japanese interest
rates are rJ = 1.00%, U.S. rates are rUS = 5%, then where would you expect
to see the one-year USD|JPY forward price to be quoted?

S(1 + rJt) 110.00(1.01)

F= = = 105.8095238 or 105.81
(1 + rUSt) (1.05)

Forward Pricing/Forward Point Exercises #3

1. The one-year forward outright market in Cable (GBP|USD):
Spot Price 1.8021 – 1.8025 (4 pips wide)
Forward Points 118 – 115 (3 pips wide)
Forward Price 1.7903 – 1.7910 (7 pips wide)
2. The six-month forward market in USD|JPY:
Spot Price 112.49 – 112.57 (8 pips wide)
Forward Points 310 – 308 (2 pips wide)
Forward Price 109.39 – 109.49 (10 pips wide)
3. The one-month forward in USD|CHF:
Spot Price 1.2498 – 1.2504 (6 pips wide)
Forward Points 27.25 – 26.75 (1/2 pip wide)
Forward Price 1.247075 – 1.247725 (61/2 pips wide)
4. If you wanted to sell USD 10,000,000 in one month, how many CHF
you would get? Selling USD 10,000,000 with F = 1.247075 (note: You
sell on the marketmaker’s bid) means you will get CHF 12,470,750.

Foreign Exchange Forward Exercises #4

1. Undertake a spot-forward arbitrage in the following circumstances:
EUR|USD S = 1.2940
t = 1 year
rUS = 3.00%
rEU = 4.00%
the one-year EUR|USD F = 1.2750
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280 ANSWERS TO THE CHAPTER EXERCISES

Do this on a spot notional of EUR 100,000,000 and check your an-

swer.
The one-year forward should be F = 1.2940 (1.03)/(1.04) =
1.28155769
so, BUY EURO FORWARD.
What this means:
BUY EUR FORWARD = SELL USD FORWARD
and SELL EUR SPOT = BUY USD SPOT.
Let’s look at the cash flows.
In the spot market
Borrow and sell EURO spot = buy and deposit USD spot
Sell EUR 100,000,000 and Buy USD 129,400,000
In one year, you’ll owe EUR 104,000,000 and own USD 133,282,000.
Now, if you sell all the USD you have at a forward price of F =
1.2750,

BUY EURO FORWARD = SELL USD FORWARD

it will translate into EUR 104,534,902 or a Euro profit of EUR

534,902.
If you had chosen to take your profit in Dollars, you’d get USD
682,000.
(Reality check: You made a little more than .5%;
1.28156/1.2750 – 1 = .005+%.)
2. What could you say about Turkish interest rates versus U.S. interest
rates if the forward points in USD|TRY are positive?
If the USD|TRY forward points are positive, then F > S, which
means (given the way this currency pair is quoted) that Turkish interest
rates are higher than U.S. interest rates (for the time horizon under
consideration).
3. What can you say about the forward points for USD|CHF if the re-
spective (zero) interest rate curves in the respective countries currencies
are as pictured in Figure 6.8 (reproduced here as Figure A.3)?
At the short end of the curve, rUS > rCH, so F will be < S and for-
ward points will be negative. Where the interest rate curves first cross,
forward points will be zero. In that range in which rCH > rUS, F will be >
S and forward points will be positive. They will go to zero once again
where the interest rate curves cross a second time, and for longer-dated
forwards, the forward points will again be negative (where rUS > rCH).
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Answers to the Chapter Exercises 281

interest rate U.S.

Switzerland

time

FIGURE A.3 Interest Rate Curves

4. If GBP|USD three-month forward is F = 1.7568 , U.S. interest rates are

4.00%, U.K. interest rates 7.00%, and we assume three months in-
volves 91 days, then
■ What is the GBP|USD spot price? Working our spot-forward rela-
tionship backward:
F = 1.7568 = S(1 + (.04)(91/360))/(1 + (.07)(91/365))
so
GBP|USD S = 1.76956748 or probably S = 1.7696
Note: For U.S. rates, we used an “actual/360” day count convention and
for U.K. interest rates, we used an “actual/365” day count convention.
■ What do you think would happen to this forward price if the
Bank of England raises interest rates? It depends on whether the
rate hike was anticipated, and whether the magnitude of the rate
hike was in line with expectations. If the rate hike was either
unanticipated or greater than expected, S will likely go up; on the
other hand, if the interest rate hike was anticipated, but the actual
increase in U.K. rates was less than expected, S will likely fall. If
the spot price is unchanged, though, then we can say that F will
go down.
■ How much would you have to pay (today) for a three-month off-
market forward of F = 1.7200 on a notional of GBP 10,000,000?
If paying in USD, it will be the PV(USD.0368 per GBP 1) × GBP
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282 ANSWERS TO THE CHAPTER EXERCISES

10,000,000 (where this is discounted using rUS) = USD

364,316.36.

CHAPTER 7 Currency Futures Exercises

1. If a U.S. corporation had a firm commitment of two billion in Japanese
Yen receivables arriving in December of that year
What futures contracts could they use to “hedge”?
Would they buy or sell them?
How many would they want to trade?
The corporation should SELL 160 (JPY 2,000,000,000/12,500,000)
December Japanese Yen futures contracts.
2. In what ways do FX futures contracts differ from FX forward con-
tracts? Exchange-traded versus OTC, standardized versus tailored
(with respect to contract size, maturity, delivery dates, and processes,
etc.), margined or marked-to-market daily versus (possibly) no cash
flows, and the majority of futures contracts do not result in delivery,
whereas many forwards do.

CHAPTER 8 Cross-Currency Swaps Exercise

Using the numbers in our earlier example: USD|CHF S = 1.2500, rUS =
5.00% and rCH = 3.00% (for all maturities):
1. Show, in two different ways, that if the U.S. corporation issues a
3.00% annual coupon bond in CHF in Switzerland and does a
cross-currency swap, then, effectively, it will be borrowing at 5.00%
in USD.
PVing the CHF cash flows (scaling for a notional of CHF 100):
(.9709)(3) + (.9426)(3) + (.9151)(3) + (.8885)(3)
+ (.8626)(103) = 100 (CHF)
PVing the USD cash flows on an equivalent amount of Dollars =
USD 80:
(.9524)(4) + (.9070)(4) + (.8638)(4) + (.8227)(4)
+ (.7835)(84) = USD 80
(Note: The USD coupon of “4” is 5% of the notional of USD 80.)
We can alternatively use the FX forward rates (calculated earlier in
Chapter 8), turn all the cash flows into one currency (say, CHF here),
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Answers to the Chapter Exercises 283

PV (using Swiss interest rates), and sum. If the result = 0, then there is
no “savings” from issuing abroad.
In Year 1 – CHF 3 + USD 4 × F1 (1.2262) = + CHF 1.9048
In Year 2 – CHF 3 + USD 4 × F2 (1.2028) = + CHF 1.8112
In Year 3 – CHF 3 + USD 4 × F3 (1.1799) = + CHF 1.7196
In Year 4 – CHF 3 + USD 4 × F4 (1.1574) = + CHF 1.6296
In Year 5 – CHF 103 + USD 84 × F5 (1.1354) = – CHF 7.6264
PVing and summing
(.9709)(1.9048) + (.9426)(1.8112) + (.9151)(1.7196)
+ (.8885)(1.6296) – (.8626)(7.6264) = 0
2. Determine the fair USD coupon for a five-year coupon-only FX swap
where one counterparty receives the 3.00% CHF on a notional of
CHF 125,000,000.
[(.9709) + (.9426) + (.9151) + (.8885) + (.8626)](3)/(1.2500)
= USD 10.9913
= [(.9524) + (.9070) + (.8638) + (.8227) + (.7835)]c
Here, USD c = 2.53875%

CHAPTER 9 Put-Call Parity Exercise #1

If a nondividend-paying stock is trading S = 78.50, the time frame is one year;
interest rates are 4.00%, and the one-year 80 strike European call is trading
at 80C = 3.75, where should the one-year 80 strike European put be trading?

C – P – S + X/(1 + rt) = 0
3.75 – P – 78.50 + 80/(1.04) = 0
80P = 2.17

Alternatively, If S = 78.50, the one-year F = 81.64 (F = S(1 + rt) =

78.50(1.04)), so the 80 call has value or is in-the-money with respect to
the forward and has an intrinsic value of 1.64. If you present value the
1.64 (= 1.58) (recalling equation [9.8]) and take that away from the 80
call, you get 2.17.
If it’s trading for .50 more than you think that it should, what trades
would you do?
Sell high. Sell the 80 put (+2.67), buy the 80 call (–3.75), and sell the
spot (+78.50). This results in a net cash inflow today of 77.42. De-
posited in the bank (at 4.00%), it will grow into 80.52. At expiration,
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284 ANSWERS TO THE CHAPTER EXERCISES

you would have to buy back the underlying at the strike price of X =
80.00, so your profit is .52. Why did you make more than .50 (your
original “edge”)? Because you waited to “capture your profits,” you
would realize an amount equal to the future value of your original
“edge”: .50 × (1.04) = .52.

FX Put-Call Parity Exercise #2

USD|JPY S = 110.00, rJ = 1.00 percent, rUS = 3.00 percent, t = 3 months
(t = 1/4 = .25)
1. For the 107.50 strike (X = 107.50) three-month European options, by
how much will the call and put differ and which will be more valu-
able?
Using equation [9.11]:
C – P = S/(1 + r2t) – X/(1 + r1t)
C – P = 110/(1 + (.03)(.25)) + 107.50/(1 + (.01)(.25))
C – P = 109.18 – 107.23 = 1.95
Since the call is in-the-money (forward), the 107.50 C is more valuable
than the 107.50 put.
Alternatively, using equation [9.12]:
C – P = (F – X)/(1 + r1t)
F = 110.00(1 + (.01)(.25))/(1 + (.03)(.25)) = 109.454
(F – X) = (109.454 – 107.50) = 1.954
and
(F – X)/(1 + r1t) = 1.954/1.0025 = 1.95
2. If the 107.50 call is trading at JPY 2.62 per USD 1, where should the
put be trading? The 107.50 call is in-the-money forward, so it
should be trading over the put by 1.95, or the 107.50 put should be
trading for JPY .67.

FX Option Premium Exercise #3

You telephone an FX option dealer/bank and ask for a three-month (t = 3/12
= .25) at-the-money European option on EUR|JPY on a notional of EUR
40,000,000. Spot is currently trading at S = 140.00, Japanese interest rates
are 1.00%, and Euro rates are 5.00%.
 10.1002/9781119201601.answ1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1002/9781119201601.answ1 by INASP - KENYA, Wiley Online Library on [08/04/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
Answers to the Chapter Exercises 285

The dealer/bank quotes the premium in Yen pips: 263.

1. What is the strike price, X?
Using simple interest: X = F = 138.62 (rounded)
(more precisely 138.617284)
2. What is this option (i.e., call or put, on what currency)?
This is either a Euro call or a Euro put;
for valuation, it doesn’t matter; at-the-money (forward) Euro-
pean calls and puts have the same value.
This is an option to exchange EUR 40,000,000 for JPY
5,544,800,000.
3. Calculate the option premium in terms of
Total EUR: EUR 751,428.57; total JPY: JPY 105,200,000.
Percent of Euro face: 1.88% (really 1.87857%);
percent of Yen face: 1.90% (really 1.89727%).
Euro pips per Yen: (remember, Euro-Yen pips go out 6 decimal
places): 135.52.

FX Option Breakeven Graph Exercise #4

1. Sketch the P/L (profit/loss) or breakeven graph of a long three-month
125.00 put with a premium of 6.58. Identify the breakeven spot price,
S*. Does it matter whether this is a three-month option or a one-year
option? Briefly explain. See Figure A.4.
Breakeven graphs are typically drawn independent of the expiration
date (so it doesn’t matter, for our graph, whether expiration is in three
months or one year), but it will impact the cash flows and, therefore,
our actual profit/loss.
 10.1002/9781119201601.answ1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1002/9781119201601.answ1 by INASP - KENYA, Wiley Online Library on [08/04/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
286 ANSWERS TO THE CHAPTER EXERCISES

P/L

+ 125 Put

X = 125.00
0
S (at expiration)
Breakeven S* = 118.42
–6.58

FIGURE A.4 Solution to FX Option Breakeven Graph Exercise #4

Profit/Loss Graph for the 125 Put.

CHAPTER 10 Exotic Option Exercise

What would you label a put option with spot at S = 22.50, strike price
at X = 20.00, and an out barrier at 21.00? What if, instead, it was
a call?
I would label this option “Stupid.” Think about it. If spot trades down
to or past 21.00, the option disappears, and this put would only have value
if the spot price ends up below the strike price of X = 20.00. Nevertheless,
we would label such an option, which goes out as the spot price moves in
the in-the-money direction a “kick out” put. With these same parameters
(S = 22.50, X = 20.00, B = 21.00), a call option would be referred to,
among other things, as a “knock out call.”