Question
Assume that the USD / AUD exchange rate (the value of 1 USD measured in AUD = how many AUD you have to pay to
Assume that the USD / AUD exchange rate (the value of 1 USD measured in AUD = how many AUD you have to pay to buy 1USD) has a volatility of =6% p.a. and a current price of =$. AUD (so we pay $2 AUD to buy 1 USD) and that the risk free rates of interest are =% . . in the US and =% . . in Australia.
Suppose we have invested in a US asset that pays us USD$10m every 6 months for 2 years and the cashflow is completely risk free in USD. We are an Australian based investor so we have exposure to foreign exchange risk and our cashflow is not risk free We receive a cashflow of $10m USD and at the current exchange rate of 1 USD = 2 AUD that converts to $20m AUD per half year.
We want to insure ourselves against the risk that the AUD income at times 0.5, 1.00, 1.5 & 2.0 years drops below $20m by purchasing the above portfolio of 4 put options. How much will it cost us to buy this "insurance"? How much would it cost if the volatility parameter changed from 6% to 12%?
Using the risk neutral valuation approach, what is the value in AUD of the future cashflows from the combination of the USD asset and the portfolio of put options?
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