QUESTION 11 10 points Save P Bonus Question A US compamy holds a volatile portfo

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QUESTION 11 10 points Save P Bonus Question A US compamy holds a volatile portfolio of Australiastocks which is expected to be sold in one year with a proceed of AUD 2 milion. Curent spot rate SSAUD You are asked to using the following tool learned from FIN178 to hedge the curreney risk for the company. Option: one-year AUD FX Option (AUDNUSD) Quotes: Exercise price: S0.7650/AUD, call premium: S0.0214 and Put premium: $0.0250 Possible actual spot rate S S/AUD in one year: S0.7530/AUD and S0.7730/AUD respectively If you use selling the option to hedge the currency risk, what is your net position (net of spot and derivative transactions) benchmarking against the current spot rate? ·A. Sell AUD call option with net profit of S22,800 if Si-s0.75 30/AUD or net profit of$46,800 if Si-so. 7730/AUD. B.Seil USD call ption with net profit of $22,800irsi-so7s30/AUD or net profit of $46,80o irs-so.7730/AUD. C Sall AUD calloption with net los of $26,800 ir si-So.7530/AUD or net loss of $42,800 ir S-S0.7730/AUD D.There is no way you can make a net profit through seling the options.

Explanation / Answer

Since we have long portfolio of Australian stocks we would be concerned about the depreciation of Australian currency (AUD). The current exchange is $ 0.7630/AUD. Based on the current exchange rate the $ value of AUD 2 mn portfolio is (2,000,000×0.7630)=$ 1,526,000

Using interest rate parity the 1 year forward exchange rate will be:

F=S× (1+rf)/(1+rd)……(1)

Where F = forward exchange rate

              S=Spot exchange rate

              rd= Domestic interest rate

              rf= Foreign interest rate

=0.7630×(1+0.003)/(1+0.01)

= 0.7630× 0.993069

=$ 0.757712/AUD

So AUD is supposed to depreciate. So we need to sell call option on AUD to hedge our current portfolio.

So our transaction will be sell 2 million call option on AUD with a strike price of $ 0.7650/AUD and receive a premium of (2,000,000×0.0214)=$ 42800. By doing so we have locked in an exchange rate of $ 0.7650/AUD.

Scenario 1: Now suppose next year spot exchange rate becomes $ 0.7530/AUD

Initial Value of the portfolio=2,000,000×0.7630) =$ 1,526,000

Current Value of the portfolio=2,000,000×0.7530=$ 1,506,000.

Hypothetical loss: (Current –Initial)= ( 1,506,000-1,526,000)=$- 20,000

Profit from option:

At the exchange rate of $ 0.7530/AUD the call option with strike of $ 0.7650/AUD will expire worthless. So we as the option seller will get to keep the entire option premium of $ 42800.

Hence net profit from the strategy: 42,800-20,000=$ 22,800.

Scenario 2: Now suppose next year spot exchange rate becomes $ 0.7730/AUD

Initial Value of the portfolio=2,000,000×0.7630) =$ 1,526,000

Current Value of the portfolio=2,000,000×0.7730=$ 1,546,000.

Hypothetical gain: (Current –Initial) = ( 1,546,000-1,526,000)=$20,000

Profit from option:

At the exchange rate of $ 0.7730/AUD the call option with strike of $ 0.7650/AUD will be in the money. So the payoff for the option seller will be negative:

-(0.7730-0.7650)×2Mn=$ -16,000

But we have also received premium of $ 42,800 from selling the option. So net profit from option:

=42,800-16,000=$ 26,800

Hence net profit from the strategy:=20,000+26,800=$ 46,800

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