A U.S.firm holds an asset in Israel and faces the following scenario:
$\begin{array}{l}\begin{array} { l } &\text { State 1}\\\text { Probability } & 25 \% \\\text { Spotrate } & \$ 0.30 / LS \\P^{*} & LS 2,000 \\P & \$ 600\end{array}\begin{array} { l } \text { State 2}&\text { State 3}\\50 \% & 25 \% \\\$ 0.20/LS & \$ 0.15 / LS \\£ 5,000 & £ 3,000 \\\$ 1,000 & \$ 4,50\end{array}\end{array}$
where,
P^* = Israeli shekel (IS) 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 Israel and faces the following scenario:

\begin{array}{l}\begin{array} { l } &\text { State 1}\\\text { Probability } & 25 \% \\\text { Spotrate } & \$ 0.30 / LS \\P^{*} & LS 2,000 \\P & \$ 600\end{array}\begin{array} { l } \text { State 2}&\text { State 3}\\50 \% & 25 \% \\\$ 0.20/LS & \$ 0.15 / LS \\£ 5,000 & £ 3,000 \\\$ 1,000 & \$ 4,50\end{array}\end{array}

where,
P^* = Israeli shekel (IS) 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

To hedge against the depreciation of the Israeli shekel, the U.S.firm needs to buy Israeli shekels forward. The amount of Israeli shekels to be bought needs to be equal to the amount of Israeli shekels the U.S. firm holds. 
In state 1, the U.S. firm holds IS 2,000, which at the spot rate of $0.30/LS is worth $600. 
In states 2 and 3, the U.S. firm holds IS 5,000 and IS 3,000, respectively, which at the respective spot rates of $0.20/LS and $0.15/LS are worth $1,000 and $450, respectively. 
Therefore, the U.S. firm needs to buy a total of IS 10,000 forward. 
Option B proposes buying 53 Israeli shekels forward, which is equal to the amount of Israeli shekels held in state 1 (IS 2,000 at spot). Thus, option B is the correct choice for effective hedging.

A USFirm Holds an Asset in Israel and Faces the Following