Consider a call option on the British pound (BP) which represents the right to purchase 1,000 at the strike price of $1.45 per . The option will expire in one year. The current spot rate is $1.45 per (at the strike). In the future, the spot rate may become $1.40 or $1.50 per . The annual risk-free interest rate is 2.0% in the US and 2.5% in the UK. A pure-discount British bond, that will pay 1,000 on the maturity date, is selling for 968.15 now.

Suppose there exists a put option that allows you to sell 1,000 at the strike price of $1.45 per .

(1) Show how you can construct a risk-free hedge portfolio using a U.K. bond and the put options on . What is the future dollar value of the hedge portfolio? (6 points)

(2) Determine the fair price of this put option using the arbitrage argument. (4 points)