A U.S. firm holds an asset in Great Britain and faces the following scenario:

State 1 State 2 State 3

Probability 30% 40% 30%

Spot rate $ 2.20/ $ 2.00/ $ 1.80/

P* 3,000 2,500 2,400

P* = Pound sterling price of the asset held by the U.S. firm

(a) (7 points) Compute the economic exposure (i.e. the regression coefficient b) to exchange rate risk.

(b) Detail a hedging strategy using a forward. Current spot rate, S(USD/GBP) = 1.98; Interest rate in US, iUS= 5.05%; Interest rate in UK, iGBP= 4%;

(c) Detail a hedging strategy using options. Strike price (USD/GBP) = 2.01054. Premium (USD/GBP) = 0.01. (d) (5 points) Compute the standard deviation of the dollar value of the asset (i.e. Std(P)) and compare it to the standard deviation of the hedged position of the forward? (i.e., Std(HP)).

What does the difference between the two represent? Comment in (less than) one line.

Question 3

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Show that a portfolio of two options can replicate a short forward. Follow the same steps as in the put-call parity derivation. Use the two following options to construct the portfolio, but remember you will be long one option and short the other:

EUR European options, maturity 3 months

Premium

Listed options Put Call

Strike Price : Nok/Eur 2:25 Nok/Eur 0.001 Nok/Eur 0.001

The forward rate is as in Task 1, that is: F(NOK/EUR) = NOK/EUR 2.25. Hint: Assume two scenarios as we did in class. One in which the spot rate at maturity is less than strike price, S(NOK/EUR) = 2.15, and one in which is higher than strike, S(NOK/EUR) = 2.35. Show how the payoff at maturity of the portfolio coincide with those of the forward.

b) Suppose now that you want to hedge your position of Task 1, EUR 250 mln, using this portfolio of options you just constructed. Compute the cash flows in each scenario, i.e., S(NOK/EUR) = 2.15 and S(NOK/EUR) = 2.35 and show that these coincide with those of the forward computed in Task 1a.