A U.S.firm holds an asset in Great Britain and faces the following scenario:
$\begin{array}{l}\begin{array} { l } &\text { State 1}\\\text { Probability } & 25 \% \\\text { Spotrate } & \$ 2.20 / £ \\P^{*} & £ 3,000 \\P & \$ 6,600\end{array}\begin{array} { l } \text { State 2}&\text { State 3}\\50 \% & 25 \% \\\$ 2.00/£ & \$ 1.80 / £ \\£ 2,500 & £ 2,000 \\\$ 5,000 & \$ 3,600\end{array}\end{array}$
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?

Question

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

\begin{array}{l}\begin{array} { l } &\text { State 1}\\\text { Probability } & 25 \% \\\text { Spotrate } & \$ 2.20 / £ \\P^{*} & £ 3,000 \\P & \$ 6,600\end{array}\begin{array} { l } \text { State 2}&\text { State 3}\\50 \% & 25 \% \\\$ 2.00/£ & \$ 1.80 / £ \\£ 2,500 & £ 2,000 \\\$ 5,000 & \$ 3,600\end{array}\end{array}

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?

Quizplus · Accepted Answer

Selling £7,500 forward at the 1-year forward rate, F1($/£), that prevails at time zero would be an effective hedge because it would offset the potential loss in the value of the asset in the event of a decline in the value of the pound sterling.

A USfirm Holds an Asset in Great Britain and Faces the the Following