You are a discount retailer selling shoes that you import from Vietnam (currency: Vietnamese Dong [VND]). They charge you 250,000 VND per shoe. The current exchange rate is 23,243 VND\/$.<\/p>
Now consider the following risk-sharing agreement:<\/p>
If the exchange rate rises above 25,000 VND\/$, the retailer will charge you 10x VND per shoe, where x is the exchange rate in VND\/$. (Note that 10 is the dollar cost of the shoe at a price of 250,000 VND if the exchange rate is 25,000 VND\/$).<\/p>
If the exchange rate falls below 21,000 VND\/$, the retailer will charge you 11.9x VND per shoe, where x is the exchange rate in VND\/$. (Note that 11.9 is roughly the dollar cost of the shoe at a price of 250,000 VND if the exchange rate is 21,000 VND\/$).<\/p>
As part of the agreement, you agree to buy 1,000 pairs of shoes at the prices set by the agreement.<\/p>
It turns out that you could essentially mimic this agreement using options. Can you describe an option strategy that you could take to limit your risk in a way that is similar to this risk-sharing agreement?<\/p>
Note that you do not know the option premia.<\/em>This is okay. This strategy likely has some cost (though it may actually end up with a net cash inflow). We are ignoring that for this question.<\/p> <\/p> To check that you have successfully mimicked the agreement, try the following:<\/p> Calculate your total cash outflows under the agreement at the following exchange rates: 20,000 VND\/$, 24,000 VND\/$, and 27,000 VND\/$.<\/p> Then, calculate your net cash outflows at maturity assuming that there isNO<\/strong>risk-sharing agreement, but that you have invested in your option portfolio. As implied above, you can ignore the option premia in these calculations and just net the option payoffs with your shoe outflows.<\/p>",
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