a. Suppose that in December 2020, the spot exchange rate for the Australian dollar was JPY 76.2025/AUD. At the same time, the one-year interest rate in Japan was 1.2% and the one-year interest rate in Australia was 3.2%. Based on these rates, calculate the one-year forward exchange rate that is consistent with no arbitrage. (2 marks)

b. Your start-up company based in Australia has negotiated a contract to provide a database installation for a manufacturing company in Japan. That firm has agreed to pay you 20,000,000 Japanese Yens (JPY) in six months time when the installation will occur. However, it insists on paying in JPY. You dont want to lose the deal but are worried about the exchange rate risk. In particular, you are worried the JPY could depreciate relative to the AUD.

(i) Explain how you can use forward and options contracts to hedge the exchange rate risk. (3 marks)

(ii) What are the advantage and disadvantage of hedging exchange rate risk with options contracts in comparison with hedging exchange rate risk with forwards contracts. (2 marks)