Suppose that you hold a stock portfolio in London Stock Exchange that you may want to liquidate in one year. The investment is $4000. As an Australian resident, you are concerned with the AUD value of the portfolio. The spot rate S0=2.00$/. Assume that if the British economy booms in the future, the portfolio will not change in value, and one British pound will be worth $1.80. If the British economy slows down, on the other hand, the portfolio will be worth less, say, decreases by 25% in value, 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. B4a) Estimate your exposure (b) to the exchange risk. (5 marks) B4b) Compute the variance of the dollar value of your portfolio that is attributable to exchange rate uncertainty. (2 marks) B4c) 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. Furthermore, compare the expected \$ value of the portfolio before and after the hedging. (8 marks) Suppose that you hold a stock portfolio in London Stock Exchange that you may want to liquidate in one year. The investment is $4000. As an Australian resident, you are concerned with the AUD value of the portfolio. The spot rate S0=2.00$/. Assume that if the British economy booms in the future, the portfolio will not change in value, and one British pound will be worth $1.80. If the British economy slows down, on the other hand, the portfolio will be worth less, say, decreases by 25% in value, 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. B4a) Estimate your exposure (b) to the exchange risk. (5 marks) B4b) Compute the variance of the dollar value of your portfolio that is attributable to exchange rate uncertainty. (2 marks) B4c) 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. Furthermore, compare the expected \$ value of the portfolio before and after the hedging. (8 marks)
