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Exchange Rate Free Options

(a) An Australian firm sold a ship to a Swiss firm and gave the Swiss client a choice of paying either AUS10,000 or SF15,000 in nine months.
(i) In the above example, the Australian firm effectively gave the Swiss client a free option to buy up to AUS10,000 using Swiss francs. What is the 'implied' exercise exchange rate? (2marks)
(ii) If the spot exchange rate turns out to be AUS0.62/SF, which currency do you think the Swiss client will choose to use for payment? What is the value of this free option for the Swiss client? (8marks)
(iii) What is the best way for the Australian Firm to deal with the exchange exposure? Explain. (8marks)

(b) Suppose a firm enters into a swap agreement with a swap dealer. Describe the nature of default risk faced by both parties. (8marks)

(c) Distinguish between the motives that excourage mergers and joint ventures among international firms and mergers and joint ventures among local firms. (8marks)

Solution Summary

The expert examines exchange rate free options. The best way for the Australian firm to deal with the exchange exposure is explained.

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