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2. (19 points)

Suppose Boeing imported a Rolls-Royce jet engine for 5 million payable in one year. The market condition is summarized as follows:

The U.S. interest rate:6.00 per annum

The U.K. interest rate:6.50 per annum

The spot exchange rate:$1.80/

The forward exchange rate:$1.75/ (1-year maturity)

Boeing can also buy a one-year call option on British pound () at the strike price of $1.80/ for a premium of $0.018 per pound.

2.1 How to hedge the foreign exchange risk of Boeing with forward contract? Choose the right answer below. (2 points)

A: Buy 5 million forwardorB:Sell 5 million forward

2.2 Compute the future dollar costs of meeting this obligation using forward hedge. (2 points)

2.3 How to hedge the foreign exchange risk with monetary market instruments? (Note: to get full points, pleasedescribe the procedureANDcalculate the dollar costs of meeting this obligation hedging with money market instruments.) (6 points)

2.4 Assuming that the forward exchange rate is the best predictor of the future spot rate, that is, the exchange rate at maturity is expected to be $1.75/.

2.4.1 What is the amount of option premium? (Ignoring the time value of the option premium) (2 points)

2.4.2 Will the call option be exercised if the spot rate is $1.75/? Choose the right answer below (2 points)

A:YesorB:No

2.4.3 What is the expected future dollar cost of meeting this obligation when option hedge is used? (Note: the premium paid to buy the option should be included. For simplicity, ignore the time value of option premium) (5 points)