A bank was expecting to receive $100 000 from its customer based in Singapore. Since the customer has problems repaying the loan immediately, the bank extends the loan for another year at the same interest rate of 10 per cent. However, in the rescheduling agreement, the bank reserves the right to exercise an option for receiving the payment in Singapore dollars, equal to S$181 500 at an exchange rate of S$1.65/$1.

a. If the cost of funds to the bank is also assumed to be 10 per cent, what is the value of this option built into the agreement if only two possible exchange rates are expected at the end of the year, S$1.75/$1 or S$1.55/$1, with equal probability?

b. How would your answer differ if the probability of the rate being S$1.75/$1 is 70 per cent and that of S$1.55/$1 is 30 per cent?

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c. Does the currency option have more or less value as the volatility of the exchange rate increases?

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