Suppose an Australian company is expected to pay 10 million euros in 6 months, it anticipates a drop in the EUR/AUD exchange rate. The following instruments are available a 6 month forward contract with forward price 1.40, a European call option with a strike of $1.40, and a European put option with strike of $1.40. The premium cost is $0.0411 for calls and puts. The cost of financing is 0% p.a., continuously compounded. For each of the following strategies, decide whether to go long or short, then draw the payoff diagram, with the EUR/AUD exchange rate on the x-axis and the net amount the company pays in 6 months on the y-axis.

NB: after taking the strategy, the company should be better off than being unhedged if the exchange rate indeed drops.

a. A forward contract on 10 million euros

(3 marks)

b. A European call option on 10 million euros

(3 marks)