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You are an exporter based in Boston. You have issued an invoice to one of your customers in Europe for 10mln, and the invoice due date is one month from today. You expect the customer to pay on time, and you would like to eliminate your exchange rate risk between today and the invoice due date completely.

The current spot exchange rate between the US Dollar and the Euro is EUR/USD 1.21 (that is, in the spot markets, 1.21 US Dollars will buy you 1 Euro). The risk-free interest rate in US Dollars is 2% per month, and the risk-free interest rate in Euros is 1% per month.

(i) Which financial instrument discussed in the course would you use to accomplish your objectives? Describe how this instrument is priced, and determine its current price. Also describe the trading strategy you would use in this case.

(ii) In one months time, the EUR/USD exchange rate turns out to be EUR/USD 1.24. What is the payoff to the trade you implemented in item (i) on that date?

[The following information applies to items (iii) and (iv) only.]

You are an investment bank, and you sold a put on stock ABC to a client. The put characteristics are as follows:

Number of shares: 10,000

Current ABC stock price: $15

Put strike price: $10

Risk-free interest rate: 2% per year (in continuously-compounded terms)

Time to expiration: 6 months

ABC stock price volatility: 40% per year

Stock ABC pays no dividends, and the Black-Scholes assumptions apply.

(iii) Under what circumstances would this trade make sense for the client?

(iv) You would like to hedge your exposure to this put by trading in the underlying stock and the risk-free asset. Compute the price of the put, the number of shares of ABC you need to buy or sell, and the amount you would have in the risk-free asset at the inception of the contract.

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