3. (4 points) Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth 2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., 1,500, but the pound will be stronger, i.e., $1.50/. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability. Your property exposure to the exchange risk can be calculated using the following information. The expected property value is E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580 The expected exchange rate is E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44 The variance of the exchange rate is Var(S) (.6)(1.40-1.44)2 + (.4)(1.50-1.44) = .00096+.00144 = .0024. The covariance between the exchange rate and the property value is 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. Cov(P,S)=(.6)(2800-2580) (1.4-1.44)+(.4)(2250-2580)(1.5-1.44) = -5.28-7.92 = -13.20 (a) (1 point) Estimate your exposure b to the exchange risk. (b) (2 points) Compute the variance of the dollar value of your property that is attributable to the exchange rate uncertainty. (Hint: the part of the total variance that equals bVar(S)) (c) (1 point) Discuss how you can hedge your exchange risk exposure and also examine the consequences of hedging.