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a U.S. firm holds an asset in Great Britain and faces the following scenario: (13 points)
| | State 1 | | State 2 | | State 3 | |
| Probability | 25% | | 50% | | 25% | |
| Spot rate | $ | 2.20 | / | | $ | 2.00 | / | | $ | 1.80 | / |
| P* | | 3,000 | | | | 2,500 | | | | 2,000 | |
| P | $ | 6,600 | | | $ | 5,000 | | | $ | 3,600 | |
| | | | | | | | | | | | | | |
P* = Pound sterling price of the asset held by the U.S. firm
P = Dollar price of the same asset
1) Compute the expected value of P and S.
2) What is the covariance of P and S?
3) Identify the value of b in the regression of the form P = a + b S + e.
4) How can this company perform an effective hedge by using financial assets (e.g., forward contract)?
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