You are working in the Forex Division of Flaggy Bank, Melbourne. You regularly report to your boss, the Manager of the Treasury and Forex Division. Suppose you observe the following interest rates, exchange rates and inflation rates between Australia and the UK.

3-month (annualized) interest rates in Australia and the UK are 7% and 3%, respectively.

Spot and 3-month forward exchange rates, respectively, are A$1.80/£ and A$1.85/£.

Inflation rates in Australia and the UK are 4% and 5.5%, respectively.

Could you advise your manager whether interest rate parity (IRP) holds between Australia and the UK? (Must show your calculations to advise your manager). If IRP does not hold, from where do you recommend that your bank should borrow and invest and why?

Assuming no transaction costs, what would your bank's covered interest arbitrage profit (or loss) be on the borrowed amount of A$1 million or dollar-equivalent pound? (Must show your workings)? 

Question :

Your Australian company has just made a contract to buy heavy machinery from a Japanese company based in Yokohama. Your company must pay Japanese company ¥500 million in three months. You have three alternatives to hedge this FX exposure: (a) buying 25-yen call options (contract size is ¥20 million) at a strike price of AUD$0.00805 per yen. The premium for this call option is 0.010 cents per yen or (b) buying 5 three‑month yen forward contracts (each worth ¥100 million) from Samurai Bank, which quotes you AUD$0.007959 per yen or (c) buying 10 three-month futures contracts, each worth ¥50 million (assume no transaction costs and no margin account requirements) at a price of AUD$0.007960 per yen. The current spot rate is ¥1 = AUD$0.007823. You forecast that the highly likely value for the yen in three months is $0.007930, but the yen could go as high as $0.008500 or as low as $0.007550. 

Discuss what kind of exposure your company has. Does it matter to remain unhedged for this exposure? Discuss your arguments.

Your company would like to decide on the contractual hedges and compare the payoffs across the hedging tools available. Calculate your company's gains or losses on the option position, forward position, and futures position if the yen is settled at its highly likely value (must show your workings). Having computed the payoffs of these three hedging tools, which strategy would you recommend and why?