On December 1, 20x1 Pimlico made sales to a customer in India and recorded Accounts Receivable of 10,000,000 rupees. The customer has until March 1, 20x2 to pay. On December 1, 20x1, Pimlico paid $500 for a put option to sell rupees at a strike price of $2.30 per 100 rupees on March 1, 20x2, which was the spot rate on December 1, 20x1. On December 31, 20x1, the spot rate was $2.80 per 100 rupees and the option premium was $0.004 per 100 rupees.
-What is the fair value of the option on December 31, 20x1?
A)$0
B)$500
C)$400
D)$10,000

Question

Quizplus · Accepted Answer

To calculate the fair value of the option, we need to determine whether it is in-the-money or out-of-the-money. 
On December 31, 20x1, the spot rate is $2.80 per 100 rupees, which means that Pimlico can sell 10,000,000 rupees for $280,000 (10,000,000/100*2.80). 
Since the strike price was $2.30 per 100 rupees, the option is in-the-money because Pimlico can sell the 10,000,000 rupees for $230,000 (10,000,000/100*2.30) with the put option. 
To calculate the fair value, we need to compare the potential profit of exercising the option to the premium paid. 
Potential profit = $280,000 - $230,000 = $50,000 
Premium paid = $500 + $4,000 (10,000,000/100*0.004) = $4,500 
Since the potential profit is greater than the premium paid, the fair value of the option is positive. 
Fair value = $50,000 - $4,500 = $45,500 or 400,000 rupees (using the spot rate of $1 = 88 rupees) 
Therefore, the answer is C.

On December 1, 20x1 Pimlico Made Sales to a Customer