Suppose that a US insurance company issued $10million of one-year zero-coupon GIC (Guaranteed Investment Contracts) denominated in British pounds at a rate of 5%. The insurance company holds no pound-denominated assets and has neither bought nor sold pounds in the market.

a) What is the firms net exposure and the nature of foreign exchange risk faced?

b) How can the firm use options to hedge this exposure?

c) If the strike price is $1.50/ and the spot price (at expiration) is $1.55/, what is the payoff of each pound option contract? The size of each option contract is 31,250.

d) Calculate the number of contracts required for fully hedging the firms foreign exchange risk.

e) If the June relevant option premium is 0.32/, calculate the total hedging cost.

f) Draw a graph depicting the payoff of the option, the balance sheet exposure and the net payoff of the strategy at expiration. Calculate the value of the latter given that the initial spot rate is $1.47/ and discuss.