Blur Ltd, a UK importer, expects to make a payment of 1.8m Australian dollars (A$) for sure in one year from now. Blur will need to pay for the A$ currency in sterling (). Assume that the Australian dollars spot exchange rate now is A$=0.56, the one-year forward rate is A$=0.59, and the discount rate is zero. Blur may need to pay an additional A$3.1m one year from now if it agrees a deal with a new Australian supplier, also payable in one year from now. The probability of this deal being agreed is 0.5. If the deal is not agreed (probability 0.5), Blur makes no payment to the new supplier.

Suppose for parts (a) and (b) that the spot rate in one year is A$=0.58.

a) Assume Blur chooses to enter into a forward exchange contract for the maximum possible payment of A$4.9m. What actions will the firm take and what will be the value of its net payments in , if in one year:

(i) the new deal is agreed?

(ii) the new deal is not agreed? What will be the expected value of Blurs net payment in ? (5 marks)

b) Assume now that Blur chooses to hedge the certain payment of A$1.8m using a forward exchange contract, and the uncertain payment of A$3.1m using a call option with an exercise price of 0.57 and a premium of 0.015 per A$. What will be the value of its net payments in from this strategy, if in one year:

(i) the new deal is agreed?

(ii) the new deal is not agreed?

What will be the expected value of Blurs net payment in ? (7 marks)

c) Suppose now that the spot exchange rate in one year is A$=0.62. What will be the new expected values in of the strategies in parts (a) and (b)? Have they changed? Explain why/why not. (7 marks)

d) Assume that Blur believes that the uncovered interest rate parity relationship determines the expected future spot rate. How might the firm set up an alternative hedging strategy for a foreign currency payable? Specify the actions that would be taken. (150 words) (No calculations are required for this part of the question.)