Suppose that you are a U.S.-based importer of goods from the United Kingdom. You expect the value of the pound to increase against the U.S. dollar over the next 30 days. You will be making payment on a shipment of imported goods in 30 days and want to hedge your currency exposure. The U.S. risk-free rate is 5.5 percent, and the U.K. risk-free rate is 4.5 percent. These rates are expected to remain unchanged over the next month. The current spot rate is $1.50. a) Indicate whether you should use a long or short forward contract to hedge currency risk. b) Calculate the no-arbitrage price at which you could enter into a forward contract that expires in three months. c) Move forward 10 days. The spot rate is $1.53 dollars per pound. Interest rates are unchanged. Calculate the value of your forward position.

A sophisticated risk management strategy called hedging involves buying or selling securities to potentially help reduce the risk of a position's possible loss.

a) According to the risk, buying more pounds will cost you more US dollars because the value of the pound will rise during the following 30 days. Thus, hedging the risk can be accomplished by entering into a forward contract to purchase British pounds.

b) T= 30/365

S0= $1.5

r = 5.5% or .055

rf = .045

Hence, F(0,T)= $1.5/(1.045)30/365 (1.055)30/365

= $1.50

c) T= 30/365

t= 10/365

T-t= 30/365 – 10/365 = 20/365

St= $1.53

r= 5.5% or .055

rf = .045

Vt (0, T)= $1.53/(1.045)20/365 - $1.50/(1.055)20/365

= $.029

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