Suppose that at date t = 0, you agree to a forward contract to buy one dollar at date t = 1 at a price of F pounds. The UK risk-free interest rate (for both borrowing and lending) over the period is rs = 3/5, (60%), and the US risk-free interest rate (for both borrowing and lending) over the period is ra= 1/2, (50%). The spot exchange rate at date t = 0 is So= 3/4 pounds per dollar (75 pence). Let S₁ denote the spot rate at date t = 1. As of date t = 0, S₁ is uncertain. You may assume there is no bid-ask spread for exchange between the pound and the dollar.
(a) Explain the position you have from the forward contract at date t = 1. If at date = 1, S₁ [3 marks]
(b) Explain how you can replicate the payoff to the forward contract using the money markets in the UK and the US and the current spot exchange rate.
[4 marks]