You are the CFO of CR7, a US based manufacturer of luxury products. The CEO has

just signed a large contract with 'Hotel de Paris' from Monaco for a large delivery of

accessories, worth 5 million. Both delivery and payment are due 18 months from

now. The current exchange rate is 1.15 $ per .

a. Represent in a figure the cash flow (in $) of CR7 in 18 months as a function

of the exchange rate, if you decide not to hedge.

b. The US interest rate is 0.15% annually (continuously compounded); the euro

area interest rate is 0.5% annually. Calculate the no arbitrage forward price

of a contract to buy 1 Euro in 18 months. Show how this currency forward

contract can be replicated by borrowing / lending $ and / or 's.

c. Describe the position in this forward contract needed to fully eliminate

exchange rate risk. Present (in the same graph as 1a) the payoffs from this

position. Indicate at which ranges of the $/ exchange rate CR7 makes a

loss and at which it makes a profit on the forward position. Also, present the

total cash flow for CR7 with this forward hedge.

d. Suppose that instead of fully hedging using a forward contract, you decide

to hedge with (European) options that mature in 18 months and have a strike

price of 1.15. Present (in the same graph as 1a and 1c) the payoff at maturity

of the option position. What type of options does CR7 buy? Present also the

total cash flow of CR7 when it hedges using options.

e. Discuss the relative attractiveness of the hedging strategies of 1c and 1d. In

your answer, assume that the price of each option (the option premium) is

0.02.