Your U.S. based company has an opportunity to break into the British market, but your CEO is concerned about the currency risk of such a venture. You estimate that sales in the United Kingdom will be £2 million (worst-case scenario)

or £5 million (best-case scenario) over the next 10 months. The likelihood that each of these scenarios will occur is equal. Your CEO wishes to hedge the expected value of these sales, but is not sure which hedging vehicle to use.

a. You are given the following information and are assigned the task of recommending the best method of hedging (that is, what is the highest dollar amount you can lock in today).

Current US$/£ spot rate  US$1.55/£

Current forward rate for currency exchanged 10 months from today  US$1.60/£

10-month US$ LIBOR is 6.5 percent per annum 10-month £ LIBOR is 11.7 percent per annum

b. Is there an arbitrage opportunity here? If so, how would you exploit it?

AppendixLO1