Question B4.

Suppose that you hold a piece of land in the city of London that you may want to sell in one year. As an Australian resident, you are concerned with the dollar value of the land. Assume that if the British economy booms in the future, the land will be worth 2,000, and one British pound will be worth $1.80. If the British economy slows down, on the other hand, the land will be worth less, say, 1,500, but the pound will be stronger, say, $2.20/. You feel that the British economy will experience a boom with a 60 percent probability and a slowdown with a 40 percent probability.Show your detailed working for full marks of this question.

Q4a.Estimate your exposure (b) to the exchange risk.(5 marks)

Q4b. Compute the variance of the dollar value of your property that is attributable to exchange rate uncertainty. (2 marks)

Q4c. Discuss how you can hedge your exchange risk exposure using forward contract. Assume the forward rate is equal to the expected spot rate.Examine the consequences of hedging and compare the resulting cash flow patterns in different states with the unhedged position.(8 marks)