Question

Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability. Assume that economic exposure measured by beta (b) is -5500. What's your risk and how could you hedge your risk in forward markets?

My risk is pound appreciation and I should sell £5500 in forward market.

My risk is pound depreciation and I should buy £5500 in forward market.

My risk is pound depreciation and I should sell £5500 in forward market.

My risk is pound depreciation and I should buy $5500 in forward market.

My risk is pound appreciation and I should sell $5500 in forward market.

My risk is pound appreciation and I should buy £5500 in forward market

Answer 1

Solution:

Correct answer is :

My risk is pound appreciation and I should buy £5500 in forward market

We are given that there is a negative exposure of 5,500. This means that if the pound appreciates then the dollar value of land will go down and similarly if the pound depreciates the dollar value of land will rise.

So, our risk is pound appreciation as this will lead to a fall in dollar value of land in london. To hedge this risk we buy £5500 in forward market. Now, if the pound appreciates in value we would gain on the forward market because we have already bought this contract at a lower rate which would hedge the loss on dollar value of land. And if the pound depreciates the loss on forward contract will be offset by a gain on the dollar value of land.