A U.S. firm holds an asset in Great Britain and faces the following scenario:

State 1 State 2 State 3

Probability25% 50% 25%

Spot rate$2.20/£ $2.00/£ $1.80/£

P*£3,000 £2,500 £2,000

P$6,600 $5,000 $3,600

where,

P* = Pound sterling price of the asset held by the U.S. firm

P = Dollar price of the same asset

Which of the following would be an effective hedge?

A)Sell £7,500 forward at the 1-year forward rate, F1($/£), that prevails at time zero

B)Buy £2,500 forward at the 1-year forward rate, F1($/£), that prevails at time zero

C)Sell £25,000 forward at the 1-year forward rate, F1($/£), that prevails at time zero

D)none of the options A U.S. firm holds an asset in Israel and faces the following scenario:

State 1 State 2 State 3

Probability25% 50% 25%

Spot rate$0.30/IS $0.20/IS $0.15/IS

P*IS2,000 IS5,000 IS3,000

P$600 $1,000 $4,50

where,

P* = Israeli shekel (IS) price of the asset held by the U.S. firm

P = Dollar price of the same asset

The "exposure" (i.e., the regression coefficient beta) is:

Hint: Calculate the expression

Cov(P,S) / Var(S)

A)-52.6316

B)1,289.80

C)12,898.00

D)none of the options Find an effective hedge financial hedge if a U.S. firm holds an asset in Great Britain and faces the following scenario:

State 1 State 2 State 3Probability25% 50% 25%Spot rate$2.20/£ $2.00/£ $1.80/£P*£3,000 £2,500 £2,000 P$6,600 $5,000 $3,600

P* = Pound sterling price of the asset held by the U.S. firm

P = Dollar price of the same asset

The CFO runs a regression of the form P = a + b × S + eThe regression coefficient beta is calculated as b =

COV(P,S)VAR(S)COV(P,S)VAR(S)

WhereCov(P,S) = 0.25 × ($6,600 − $5,050) × ($2.20 − $2.00) + 0.50 × ($5,000 − $5,050) × ($2.00 − $2.00) + 0.25 × ($3,600 − $5,050) × ($1.80 − $2.00)Cov(P,S) = 77.50 + 0 + 72.50Cov(P,S) = 150b =

1500.021500.02

=7,500The variance of the exchange rate is calculated asE(S) = 0.25 × $2.20 + 0.50 × $2.00 + 0.25 × $1.80= $.55 + $1 + $.45= $2.00

VAR(S) = 0.25($2.20 − $2.00)2 + 0.50($2.00 − $2.00)2 + 0.25($1.80 − $2.00)2= 0.01 + 0 + 0.01= 0.02The expected value of the investment in U.S. dollars is:E[P] = 0.25 × $6,600 + 0.50 × $5,000 + 0.25 × $3,600 = $5,050

Suppose that you implement your hedge at F1($/£) = $2/£. Your cash flows in state 1, 2, and 3 respectively will be

A)$5,100, $5,000, $5,100

B)$5,100, $5,100, $5,100

C)$5,000, $5,000, $5,000

D)none of the options