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, we 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 $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.
(a) Estimate your exposure b to the exchange risk.
(b) Compute the variance of the dollar value of your property that is attributable to the exchange rate uncertainty.
(c) Discuss how you can hedge your exchange risk exposure and also examine the consequences of hedging.