Question 6 Auron Inc, a US car manufacturing firm, expects to have cash inflow of 1 million in one year from exporting its products to the UK. Auron's directors are concerned about the exposure risk that they face from changes in the exchange rate between the US dollar and sterling (). The spot exchange rate now is 1=$1.25, and the one-year forward exchange rate is 1=$1.20. One-year put options on sterling are available with an exercise price of $1.20 and a cost of $0.04 per . The one-year interest rates (for either borrowing or depositing money) are 5.0% for sterling and 3.5% for the dollar. (a) Assume Auron chooses to buy put options to hedge its exposure risk from the cash flow of 1 million. What will be Auron's expected net receipt in dollars if the forecast spot exchange rate in one year is: (i) 1=$1.23 (probability 0.5 ); (ii) 1=$1.18 (probability 0.5) ? (7 marks) (b) (i) Explain briefly how the one-year forward price of sterling, in dollars, should be linked to the spot exchange rate now and the interest rates of the two countries. Using the covered interest rate parity relationship, what is the expected forward price in this case? (6 marks) (ii) Assume Auron can borrow $50,000 now. Using the information provided in this question, explain whether (or not) there is an opportunity for the firm to profit from a covered interest arbitrage strategy. What, if any, profit can the firm make from this? ( 6 marks) (c) Explain what is meant by 'uncovered interest rate parity' and the carry trade strategy used by traders. How might this strategy result in the traders making a profit? Why, or why not, does the carry trade provide an arbitrage opportunity? (maximum of 150 words) (6 marks)