Question

A U.S. firm holds an asset in Great Britain and faces the following scenario:

	State 1				State 2				State 3
Probability	25%				50%				25%
Spot rate	$	2.50	/£		$	2.00	/£		$	1.60	/£
P*	£	1,800			£	2,250			£	2,812.50

Where

P^* = Pound sterling price of the asset held by the U.S. firm

The CFO decides to hedge his exposure by selling forward the expected value of the pound denominated cash flow at F₁($/£) = $2/£. As a result,

Multiple Choice

• he has a perfect hedge.

• the firm's exposure to the exchange rate is made worse.

• none of the options

• he has a nearly perfect hedge.

Answer 1

answer is option B

the firm's exposure to the exchange rate is made worse.

When there is volatilities in relevant currencies, the emphasis of firms on foreign exchange exposure increases. Here the market is performing well or mostly moving in the favorable direction and in this case, because of hedging and the firm's exposure to the exchange rate, the situation will get worse.