Problem 1 (Hedging)

A US exporter expects to receive 1 million in 2 months for her exports to the UK. The current exchange rate is US$2.30/. She is worried that the pound might depreciate over the next 2 months and wants protection against its decline but she also want to benefit from a possible rise in over the next 2 months. Put options and call options on the , with 2-month maturity are available.

1. What should she do?

2. Suppose the 2-month put options exercisable at US$2.50/ are trading at US$0.01. What would be her cash revenue, given your answer in part a), if at the 2 month end the spot exchange rate turns out to be

   1. US$2.00/

   2. US$3.00/

3. What would be her minimum cash revenue, no matter what the spot rate at the end of 2 months turn out to be?

4. What would be the upfront cost (fee) for undertaking the appropriate options contract?

5. What would she do if the expected 1 million at the 2-month end are not received and what would be her loss if that happens?