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Expecting a shipment of goods

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You operate a business in Australia that frequently imports goods from partners in China. As a result, you often need to make payments denominated in Renminbi (RMB). This exposes you to foreign exchange risk, therefore you make use of option contracts to manage this risk. The spot exchange rate between AUD and MB is RMB1.0000 = AUDO.2200. The riskfree rates of interest (continuously compounded) in Australia and China are 2% and 4% respectively. The volatility of the MB/AUD exchange rate is 10% pa.

In this particular case you are expecting a shipment of goods from China in three (3) months' time and you will need to pay RMB1,000,000 for the goods. You decide to use an at-the-money spot (Strike price is RMB1=AUD0.2200) 3-month maturity option to hedge your exposure.

1. In this particular case your business is exposed to of the RMB.

2. One strategy you could use to hedge your exposure to currency risk is to purchase a option on RMB1.000.000

3. Using the BSM model for currency options (the Garman-Kohlhagen model), the cost of this option is AUD( whole number to the nearest dollar.)

4. Suppose in three months time the exchange rate is RMB1=AUDO.2500. Then the total cost in AUD (including the cost of the option-ignore the time differential between payment of the option premium and payment for the goods) is AUD

Reference no: EM133123143

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