(a) Suppose the USD-sterling spot exchange rate is 1.3080, the 90-day forward exchange rate is 1.3056, and the 90-day European put option to sell £1 for $1.34 costs 2 cents. Construct an arbitrage trading strategy. Show the profit of the trading strategy when the exchange rate in 90 days is greater than 1.34, and when it is less than 1.34 respectively. Assume the risk-free rate is zero.

(b) An Australian company is expected to pay 2 million euros in 6 months. It decides to sell European put options to hedge against its exposure to foreign exchange rate risk. Carefully explain why this strategy does not actually hedge the company’s risk exposure.

Answer rating: 100% (QA)

Solution Answer a arbitrage means risk free return I e return without 0 risk Forward exchange 11... View the full answer