Problem:
Suppose that you hold a piece of land in the city of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that if the British economy booms in the future, the land will be worth £2,000, and one British pound will be worth $1.50/£. If the British economy slows down, on the other hand, the land will be worth less, say, £1,500, but the pound will be weaker, say, $1.40/£. You feel that the British economy will experience a boom with a 60 percent probability and a slowdown with a 40 percent probability.
a. Estimate your exposure to the exchange risk.
b. Compute the variance of the dollar value of your property that is attributable to exchange rate uncertainty.
c. Discuss how you can hedge your exchange risk exposure and examine the [possible] consequences of hedging.