This problem illustrates hedging with currency futures. The questions lead you through the process of hedging. While this material was not explicitly covered in the text material, your instructor may use this problem to show how hedging may reduce the risk of loss from fluctuations in the price of a foreign currency. You expect to receive a payment of 1,000,000 British pounds after six months. The pound is currently worth $1.60 (i.e., ₤1 = $1.60), but the six-month futures price is $1.56 (i.e., ₤1 = $1.56). You expect the price of the pound to decline (i.e., the value of the dollar to rise). If this expectation is fulfilled, you will suffer a loss when the pounds are converted into dollars when you receive them six months in the future.

a) Given the current price, what is the expected payment in dollars?

b) Given the futures price, how much would you receive in dollars?

c) If, after six months, the pound is worth $1.35, what is your loss from the decline in the value of the pound?

d) To avoid this potential loss, you decide to hedge and sell a contract for the future delivery of pounds at the going futures price of $1.56. What is the cost to you of this protection from the possible decline in the value of the pound?

e) If, after hedging, the price of the pound falls to $1.35, what is the maximum amount that you lose? (Why is your answer different from your answer to part [c]?)

f) If, after hedging, the price of the pound rises to $1.80, how much do you gain from your position?

g) How would your answer be different to part (f) if you had not hedged and the price of the pound had risen to $1.80?