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Suppose today is 15 June 2016. The spot exchange rate between Australian dollars and the U.K. pound today is $2 per 1, E$/ = 2.00. The one month interest rate (for both deposit and borrowing) in Australia is 0.2%. The one month interest rate (for both deposit and borrowing) in the U.K. is 0.3%. You and the financial market in general believe that with the probability of 50% the people in the U.K. will vote on YES to Brexit and the Australian dollar will appreciate by 10% to E$/ = 1.80, and with the probability of 50%, the people will vote on NO to Brexit and the Australian dollar will depreciate by 5% to E$/ = 2.10. Thus, the expected exchange rate in 1 month is Ee $/ = 0.51.8+0.52.10 = 1.95. Assume that the covered interest parity holds.

(A) Today you sold Australian wine to an importer in the U.K. The payment of 100,000 is due on receipt of the shipment and will be delivered to you on 15 July 2016 (30 days from today).

(i) Calculate the payment in Australian dollars if the exchange rate becomes E$/ = 1.80 on 15 July.

(ii) Calculate the payment in Australian dollars if the exchange rate becomes E$/ = 2.10 on 15 July.

(iii) Assume that the covered interest parity holds. Calculate the 1-month forward exchange rate, F$/, under the covered interest parity (rounding to 3 decimal places).

(iv) Assume that the covered interest parity holds. Explain how you can avoid the exchange rate risks completely. [Hint: Consider hedging currency risk using forward markets and calculate all amounts involved in the transaction]

(B) Assume that the covered interest parity does not hold. The 1-month forward exchange rate, F$/, is $1.95 per 1. Assume further that you can borrow $2 million from a bank in Australia or 1 million from a bank in the U.K. Explain how you can make money without any exchange rate risks. The answer should have the specific amount of risk-free profits in Australian dollars in 1 month. Hint: Show all the steps of your investment and the amounts involved and do not forget to pay the principal and interests after 1 month.

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