1. Suppose you are a US based importer of goods from the UK. You expect the value of the UK pound to increase against US dollar over the next year. You will be making payment on a shipment of imported goods in 1 year and want to hedge your currency exposure.

Assume the US money market rate is 3.6% and the UK money market rate is 2.8%. The current spot rate is $1.50/. Also assume that premium on a call option expiring 1 year from now and with a strike/exercise price of $1.46/ is $0.03/.

1. Should you use a long or short forward contract on the UK pound to hedge the currency risk? What should the no-arbitrage 1-year forward rate be?
2. At what future spot exchange rate 1 year from now will you be indifferent between the forward and option hedges?
3. Based on your solutions to parts a. and b. above, which hedging alternative should you choose?
4. It is now 6 months since you entered into the forward contract (assuming you chose to use the forward hedge alternative). The spot rate is $1.53/ and interest rates are the same as before. What is the value of your forward position?
5. It is now 6 months since you entered into the option contract (assuming you chose to use the option hedge alternative). The spot rate is $1.53/ and interest rates are the same as befor What is the value of your option position if you choose to exercise it?