XYZ is a U.S. firm that holds some bonds in the United Kingdom and faces three different scenarios in one year's time: With 50% probability, the spot exchange rate will be $2.00/ and the dollar price of the bonds will be $5,000; with 25% probability, the spot exchange rate will be $2.20/ and the dollar price of the bonds will be $4,400; with 25% probability, the spot exchange rate will be $1.80/ and the dollar price of the bonds will be $5,400.

(a) (2 points) What is the mean value (in US dollars) of the British bonds?

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(b) (3 points) What is the variance of the spot $/ exchange rate?

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(c) (4 points) To fully hedge the exchange rate exposure of the British bonds, should the US firm buy or sell pounds in the forward market? And what is the amount in pounds the US firm should buy or sell in the forward market?

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(d) (3 points) What is the percentage of the total variance of the British bonds (in US dollars) that cannot be removed by hedging at the amount found in part (c)?

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