You are the manager of a stock portfolio for a financial institution, and about 20 percent of the stock portfolio that you manage is in British stocks. You expect the British stock market to perform well over the next year, and you plan to sell the stocks one year from now (and will convert the British pounds received to dollars at that time). However, you are concerned that the British pound may depreciate against the dollar over the next year.
(i) Explain how you could use a forward contract to hedge the exchange rate risk associated with your position in British stocks.
(ii) If interest rate parity holds, does this limit the effectiveness of a forward rate contract as a hedge?
(iii) Explain how you could use an options contract to hedge the exchange rate risk associated with your position in stocks.
(iv) Assume that while you are concerned about the potential decline in the pound's value, you also believe that the pound could appreciate against the dollar over the next year. You would like to benefit from the potential appreciation of the pound but wish to hedge against the possible depreciation of the pound. Should you use a forward contract or options contracts to hedge your position? Explain.