You own a store in Canberra that sells antique prints and books sourced from around the world. You have just arranged to purchase a large collection of 17^th century equestrian lithographs from an antique dealer in the United Kingdom. You have arranged to pay the dealer GBP 375,000 on delivery three months from now.

To protect yourself against adverse movements in the exchange rate, you have decided to hedge your foreign exchange risk through GBP options with a strike price equal to the current exchange rate of 0.56 (1 AUD = 0.56 GBP). Given this information, answer the following questions:

a) How would you use these options to place a ceiling (maximum) on your AUD cost of purchasing the lithographs? In providing your answer, show that your strategy works if the exchange rate three months from now is 0.46 or 0.66. (7 marks)

b) Draw a labelled diagram depicting your overall net AUD outflow as a function of the exchange rate in three months time. In doing so, show that the strategy detailed in (a) does indeed place a ceiling on the AUD cost from the purchase of the lithographs (Note: in answering this question you can ignore option premiums and assume that the exchange options are European in style). (3 marks)

c) Although you chose to hedge your risk using options, you could have chosen to hedge the risk using a forward contract instead. Describe one advantage and one disadvantage of using forward contracts instead of options to hedge your risk. (2 marks)