Assume that a UK bank has assets located in New York worth $150 million on which it earns an average of 8 percent per year. The bank has 75 million worth of liabilities on which it pays an average of 3 percent per year. The current spot exchange rate is $2.00/ .

a. What risk is the bank facing? Explain.

b. If the exchange rate at the end of the year is $2.1/, what is the effect on the bank's net interest margin?

c. Suppose there are call and put options with strike price $2.06/, premium 0.005/$ and maturity end of the year. How can the bank use options to hedge its FX exposure? Draw the payoff profile of the option position, the asset value and the net payoff.

d. Calculate the cost of hedging and the net payoff.