Consider a call option on the British pound (BP) which represents the right to purchase 1,000 at the strike price of $1.45 per . The option will expire in one year. The current spot rate is $1.45 per (at the strike). In the future, the spot rate may become $1.40 or $1.50 per . The annual risk-free interest rate is 2.0% in the US and 2.5% in the UK. A pure-discount British bond, that will pay 1,000 on the maturity date, is selling for 968.15 now.

(1) If you buy a British bond, how many calls do you have to buy or sell to construct a risk-free hedge portfolio? What is the future dollar value of the hedge portfolio? (10 points) (2) What is the fair price of this call option? (4 points) (3) Suppose the call is trading for $20 per contract. Show how you can realize arbitrage profit and determine the profit. Assume you buy or sell one unit of British bond. (6 points)