a) With the use of an appropriate illustration, explain the mechanism and benefit to be derived from an interest rate collar. [8 marks]

b) Given the following information:

Asset = Gold

Interest rate = 3%

Time to expiration = 6 months

Spot Price = $ 1,235

Strike Price = $ 1,225

Standard Deviation = 0.1

(i) Calculate, using the Black-Scholes formula, the value of a Call Option.

(ii) Using your answer from (i), determine the value of the Put Option. [4+ 2 = 6 marks]

(c) A company in Italy expects to pay US$2 million to a supplier in Saudi Arabia. It is now November and the payment is due in March. The current spot rate is 1 = US$ 1.2100. The company wants to use currency options to hedge the exposure. March currency put options are available and are for 125,000 euros, have a strike price of $1.2200 and the tick size is $0.0001. The cost of the option contract is 2.75 US cents per euro. Assuming that there is no basis,

(i) Devise a hedging strategy for the Italian company using currency options. [3 marks]

(ii) Advise on the action to be taken by the company and the outcome in case the spot rate in March when the dollars must be paid is

(a) 1 = US$1.2500

(b) 1 = US$1.1800