7. An option based hedging strategy is useful when there is an element of uncertainty present in a firms cash flows. A US firm with a subsidiary in Australia is facing a difficult situation. The Australian company has begun the appeal process of a patent infringement lawsuit that it won two months ago. Two months from today (July) the appeal decision will be rendered. The losing party in the case has 500,000 A$ (Australian dollars) in escrow pending appeal. If the verdict is upheld, the Australian subsidiary will repatriate the recovery to the US parent in the US to help cover expenses associated with the case by converting the A$ into USD. If the appeal is reversed, then the recovery is lost. Current July puts on A$ are trading at a strike price of 79 cents US/A$ with a premium of 1.35 cents US/A$. The current spot exchange rate is 77.82 cents US/A$. Each contract is for A$ 50,000.

a. Devise an appropriate hedging strategy for the expected cash flow using the available July puts. Discuss the number of contracts to use as well as the premium necessary to establish the hedge.

b. In July, the appeal is won and we have to close out the hedge. Current spot is 78 cents US/A$. Compute the USD value of the settlement won in the case by the Australian subsidiary. Now compute the profit/loss on the hedge assuming the closing spot for options purposes is also 78 cents US/A$.

c. Was the hedge successful? Did the exchange rate move with the company or against the company and did they net a positive amount on the options position? Explain.