Assume you can buy any fraction of any security you need. Assume all securities are priced with precision 10 significant digits. (e.g do not round prices or number of securities during computation, show at least 5 significant digits in your final results.

You and your best friend Gael work for two different companies. Your company needs to sell 50 000 000 pounds in exactly two years. Gael's company needs to do the same. The spot exchange rate is (1.2301+729/10000)$/. The current two year interest rate in the US is 1.85%, while in the GB the current two year interest rate is 0.75% (both rates assume discrete annual compounding).

a. What is the method to hedge the exchange rate risk?

b. What is the arbitrage free 2-year forward exchange rate?

c. If the 2-year forward exchange rate is 1.2377$/ - can you spot an arbitrage and make a profit on it? How? Give details.

d. Assume that you decided to hedge the risk with arbitrage free 2-year forward and Gael decided to take chances (no hedge). Who is better off and by how much if the spot exchange rate in two years will happen to be

1 - 1.2473$

2 - 1.28002$

3 - 1.3918$/

Draw a table what shows your and Gael's cashflow by selling Pounds and explain why some prefer to hedge and some prefer not to do so.

e. After you signed the forward contract you decided to sell it in exactly one year Assume you have somebody who agree to assume it. The then-current exchange rate is 1.2473$ (assume interest rates stay the same). What transaction should you do in order to transfer the forward to another party?