Information:

Your employer, an Australian-based investment bank, has issued a Structured Financial Product (SFP) to high net worth investors. You have been requested to determine the risk exposure to the bank and to hedge the market financial risks associated with the payoff at maturity on the SFP.

You have the following information on this SFP, as well as other information on key financial variables:

• The face value of the SFP is USD25,000
• The payoff is due in one year
• Payoff at maturity is max{USD25,000, [(SP500_T/SP500₀ )x USD25,000]}
• SP500_T represents the value of the S&P 500 Index at maturity of the investment product and SP500₀ the value of the S&P 500 Index at inception of the SFP (i.e., the end of June 2020)
• USD/AUD represents the US dollar/Australian dollar exchange rate (price of AUD 1 in USD)
• The discount rate for this SFP is the yield on the comparable U.S. government bond plus 200 basis points
• You have been provided with time series data (as of the end of June 2020, the date you will assume as now/today for undertaking your calculations) in the form of the yield on U.S. government bonds (% p.a.), the USD/AUD exchange rate, and the value of the S&P 500 Index
• Briefly outline how you would hedge against the market risk exposure(s) associated with the payoff on this structured investment product.