A foreign exchange trader assesses the euro exchange rate three months hence as follows:
$1.11 with probability 0.25
$1.13 with probability 0.50
$1.15 with probability 0.25
The 90-day forward rate is $0.12.
a. Will the trader buy or sell euros forward against the dollar if she is concerned solely with expected values? In what volume?
b. In reality, what is likely to limit the trader's speculative activities?
c. Suppose the trader revises her probability assessment as follows:
$1.09 with probability 0.33
$1.13 with probability 0.33
$1.17 with probability 0.33
If the forward rate remains at $1.12, will this new assessment affect the trader's decision? Explain.