Suppose S0$/£ = $1.25/£, F1$/£ = $1.2/£, i£ = 11.56%, and i$ = 9.82%. You are to receive £100,000 on a shipment of Madonna albums in one year. You want to fix the amount you must pay in dollars to avoid foreign exchange
risk.
a. Form a forward market hedge. Identify which currency you are buying and which currency you are selling forward. When will currency actually change hands- today or in one year?
b. Form a money market hedge that replicates the payoff on the forward contract by using the spot currency and Eurocurrency markets. Identify each contract in the hedge. Does this hedge eliminate your exposure to foreign exchange risk?
c. Are these currency and Eurocurrency markets in equilibrium? How would you arbitrage the difference from the parity condition?