Trefor, a US firm, has a sterling () receivable of 300,000 from a UK customer due one year from now. Trefor has no use for sterling currency and will exchange the receipt into US dollars ($). The spot exchange rate now is 1=$1.34 and the one-year forward exchange rate is 1=$1.31. Assume the forecasted spot rate in one years time is 1=$1.28 or 1=$1.38, with equal probability. The discount rate is zero.

(a) What is the expected dollar value of Trefors receivable if it chooses:

(i) not to hedge the receipt?

(ii) to use a forward hedge?

(b) One year sterling put options and sterling call options are available at a cost of $0.03 per with an exercise price of 1.32.

(i) How could Trefor make use of an option hedge for its sterling receivable?

(ii) What will be the expected value in dollars of the outcome of the option hedge?

(c) If Trefor is concerned only about downside risk, is it better to choose the forward hedge or the option hedge? Explain.

(d) An alternative hedging strategy for Trefor is to use futures contracts. Are there any advantages to using futures instead of a forward exchange extract? Explain. (60 words)

(e) Briefly discuss the implications of the Capital Asset Pricing Model for the relationship between the current spot price of an asset and the discount offered by the seller of a futures contract. (100 words)