1. Let the current spot rate be $1.25 >:, and assume that 1 month from now the spot rate will be either $1.30 >: or $1.20 >:. Let the dollar interest rate be 0.4% per month, and let the euro interest rate be 0.3% per month. Develop a portfolio that replicates the payoff on a 1-month euro call option with a strike price of $1.25 >:. What is the corresponding price of the euro put option with the same strike price?
2. Suppose that the price of the euro call option in Problem 1 were $0.03 >:. How would you arbitrage between the market in risk-free assets and the foreign currency options market? What would you do if the price of the call option were $0.02 >:?