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) 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.