How many pounds would the investor in Example 19.2 need to sell forward to hedge exchange rate risk if: 

(a) r(UK) = 20%; and 

(b) r(UK) = 30%?

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If the futures exchange rate in Example 19.1 had been Fo= $1.93/£ when the investment was made, the U.S. investor could have assured a riskless dollar-denominated return by locking in the year-end exchange rate at $1.93/£. In this case, the riskless U.S. return would have been 6.15%: [1 + rf (UK)]Fo/Eo = (1.10) 1.93/2.00 = 1.0615 Here are the steps to lock in the dollar-denominated returns. The futures contract entered in the second step exactly offsets the exchange rate risk incurred in step 1. Initial Transaction Exchange $20,000 for £10,000 and invest at 10% in the United Kingdom. Enter a contract to deliver £11,000 for dollars at the (forward) exchange rate $1.93/£. Total End-of-Year Proceeds in Dollars £11,000 X E₁ £11,000(1.93 E1) £11,000 x $1.93/£ = $21,230 EXAMPLE 19.2 Hedging Exchange Rate Risk