The current exchange rate is AU$1 buys US$0.83. In your answers, you must always

Question

The current exchange rate is AU$1 buys US$0.83. In your answers, you must always specify if the $ are AU or US. The up factor is u = 1.04 and the down factor is d = 0.98. The domestic return over each time step is 1.060 and the US return over each time step is 1.055.

(a) An Australian company needs to pay its US supplier US$600 000. The payment is due in three time steps.

(i) If the company does not buy an option, then, in three time steps, what are the four possible amounts the Australian company must pay its supplier, in Australian dollars?
(ii) To avoid potential losses due to the fluctuating exchange rate, this Australian company buys a European option with face value F = US$600 000 . Does the company buy a put or a call? Explain your answer.
(iii) What is the premium of the option described in part (d)(ii).
(iv) Show that by buying the option described in part (d)(ii), in three time steps this Australian company will pay no more than F k = AU$750 000

Explanation / Answer

Answer (i)

Australian company must pay its supplier, in convert Australian dollars into US dollars and pay it.

Answer (ii)

To avoid potential losses due to the fluctuating exchange rate, company will buy call option it will be beter for to avoid potential losses and decrease the tax rates.

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