Question: Consider the two options (call on Euro) proposed to the company in Exhibit 1. Calculate their exercise price (rounded to the fourth decimal) (5), their premium (expressed as a percentage of the Euro face value rounded to the second decimal) (5) and explain why the premium of one call is larger than that of the other call. (5)

Hint: In the case, the premium is expressed in percentage of the AUD face value. However, we typically expressed the premium in the percentage of the foreign currency (the Euro in this case). To answer this question, you need to adjust the premium so that it is a premium for each contract on one unit of Euro. For example, the premium for the first option is 2.13% of the AUD face value. This means that the premium is 2.13% * 1.4472 =3.08% of the Euro face value (rounded to the second decimal). So It will cost AUD3.08 to buy the first option on Euro100. 5) Assume the company has a Euro payable 15M and they decide to hedge it

Exhibit 1Purchase an AUD Put/EUR Call Option

All pricing is indicative and based off spot AUD/EUR 0.6980. The four (4) month FEC (Foreign Exchange Forward contract) is 0.6910 (spot of 0.6980 less 70 forward points).

Expiry Date: 2015-01-14 (four months) Value Date: 2015-01-16 Strike 1: 0.6910 (at-the-money fwd) Strike 2: 0.6860 (50 pips out-of-the-money (OTM)) Premium 1 2.13% of AUD face value (~146 AUD/EUR pips) Premium 2: 1.81% of AUD face value (~124 AUD/EUR pips)

This solution gives you the right but not the obligation to buy EUR and sell AUD at the strike rate on the expiry date. On the expiry date, if the prevailing spot AUD/EUR is below the strike rate, then you will exercise the right to deal at the higher strike rate. Conversely, if the prevailing spot AUD/EUR rate is higher than the strike rate, then you will let the option lapse and buy EUR against the AUD in the spot market at the higher rate. I have provided you with two prices so you can see the relationship between premium and strike prices.