1. Suppose you are a portfolio manager of a U.S. mutual fund. Your portfolio consists entirely...

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1. Suppose you are a portfolio manager of a U.S. mutual fund. Your portfolio consists entirely of British government bonds. For simplicity assume that the bonds have a face value of 3,000,000 and will mature on December 31, 2020. You are convinced that the US$ will appreciate until then. Further suppose that the British pound currently trades at an exchange rate of 1 = US$2. Futures contracts and options with an exercise price equaling the same 1: US$2 exchange rate are currently available for purchase. For simplicity, assume that each futures and options contract is based on a currency basket of 50,000. Also, for simplicity, assume that the price of a call option (i.e. the call option premium) is US$500, while the price of a put option (the put option premium) is US$300. a) Do you currently have a long or short position in the spot market? In which currency are you long/short, given your perspective as a U.S. based fund manager? b) If your goal is to minimize your firm's exchange rate risk, should you hedge your position? Why or why not? c) If yes, which hedging strategies could you pursue? Specifically, should you take a long or short position in the futures market or, alternatively, should you buy a call or put option contract? d) Draw a graph that displays the expected profit/loss of your unhedged (spot) position. Use different realizations of the US$/ exchange rate to label your x-axis and calculate the corresponding US$ profit/loss from your unhedged position on the y-axis. Assume that the British pound could either appreciate by 10%, depreciate by 10% or remain unchanged relative to the US dollar. e) Draw a graph that displays the expected profit/loss of the futures contract you plan to enter into. (Follow the same approach you used to draw the graph in question c.) How many futures contracts should you buy? What is your profit/loss in US$ if the British pound depreciates by 10% until December 31? f) Draw a graph that displays the expected payoff and profit/loss of the options contract you plan to enter into. (Follow the same approach you used to draw the graph in question c.) How many option contracts should you buy? Note that your profit/loss diagram should take the option premium into consideration while the payoff diagram should not. What is your profit/loss in US$ if the British pound depreciates by 10% until December 31? g) Draw a graph that displays the expected profit/loss of your hedged position (i.e. your combined spot and futures position, based on the hedging strategy you recommended in question e (using futures). What is the total profit/loss in US$ you would realize under that strategy if the British pound depreciates by 10% until December 31? h) Draw a graph that displays the expected profit/loss of your hedged position (i.e. your combined spot and options position, based on the hedging strategy you recommended in question f (using options). What is the total profit/loss in US$ you would realize under that strategy if the British pound depreciates by 10% until December 31? 1. Suppose you are a portfolio manager of a U.S. mutual fund. Your portfolio consists entirely of British government bonds. For simplicity assume that the bonds have a face value of 3,000,000 and will mature on December 31, 2020. You are convinced that the US$ will appreciate until then. Further suppose that the British pound currently trades at an exchange rate of 1 = US$2. Futures contracts and options with an exercise price equaling the same 1: US$2 exchange rate are currently available for purchase. For simplicity, assume that each futures and options contract is based on a currency basket of 50,000. Also, for simplicity, assume that the price of a call option (i.e. the call option premium) is US$500, while the price of a put option (the put option premium) is US$300. a) Do you currently have a long or short position in the spot market? In which currency are you long/short, given your perspective as a U.S. based fund manager? b) If your goal is to minimize your firm's exchange rate risk, should you hedge your position? Why or why not? c) If yes, which hedging strategies could you pursue? Specifically, should you take a long or short position in the futures market or, alternatively, should you buy a call or put option contract? d) Draw a graph that displays the expected profit/loss of your unhedged (spot) position. Use different realizations of the US$/ exchange rate to label your x-axis and calculate the corresponding US$ profit/loss from your unhedged position on the y-axis. Assume that the British pound could either appreciate by 10%, depreciate by 10% or remain unchanged relative to the US dollar. e) Draw a graph that displays the expected profit/loss of the futures contract you plan to enter into. (Follow the same approach you used to draw the graph in question c.) How many futures contracts should you buy? What is your profit/loss in US$ if the British pound depreciates by 10% until December 31? f) Draw a graph that displays the expected payoff and profit/loss of the options contract you plan to enter into. (Follow the same approach you used to draw the graph in question c.) How many option contracts should you buy? Note that your profit/loss diagram should take the option premium into consideration while the payoff diagram should not. What is your profit/loss in US$ if the British pound depreciates by 10% until December 31? g) Draw a graph that displays the expected profit/loss of your hedged position (i.e. your combined spot and futures position, based on the hedging strategy you recommended in question e (using futures). What is the total profit/loss in US$ you would realize under that strategy if the British pound depreciates by 10% until December 31? h) Draw a graph that displays the expected profit/loss of your hedged position (i.e. your combined spot and options position, based on the hedging strategy you recommended in question f (using options). What is the total profit/loss in US$ you would realize under that strategy if the British pound depreciates by 10% until December 31?

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a As a USbased fund manager holding British government bonds you have a long position in the spot market in British pounds GBP This means you are long ... View the full answer