ANSWER KEY (Additional Problems on Operating Exposure)

1. 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

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rate uncertainty.

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(c) Discuss how you can hedge your exchange risk exposure and also examine the consequences

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of hedging.

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rs e
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Solution: (a) Let us compute the necessary parameter values:
E(P) = (.6)(2800)+(.4)(2250) = 1680+900 = $2,580
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E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44

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Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2

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= .00096+.00144 = .0024.
Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)
ed d

= -5.28-7.92 = -13.20
ar stu

b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.

You have a negative exposure! As the pound gets stronger(weaker) against the dollar, the dollar
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value of your British holding goes down(up).

(b) b2Var(S) = (-5500)2(.0024) =72,600($)2 (this is the variance that can be eliminated through
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hedging)
(c) Buy £5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your
British asset that is due to the exchange rate volatility.
The variance of the dollar value of the asset is :
Var(P) = 0.6 (2800 – 2580)2 + 0.4 (2250 – 2580)2 = 72,600. This is the same as the variance that
can be eliminated through hedging! Hence- if we hedge the variance will be completely
eliminated. The variance of the dollar value of the hedged asset is zero.

https://www.coursehero.com/file/14036036/Answer-Key-Additional-Problems-on-Operating-Exposure/
 2. A U.S. firm holds an asset in France and faces the following scenario:

State 1 State 2 State 3 State 4

Probability 25% 25% 25% 25%

Spot rate $1.20/€ $1.10/€ $1.00/€ $0.90/€

P* €1500 €1400 €1300 €1200

P $1,800 $1,540 $1,300 $1,080

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In the above table, P* is the euro price of the asset held by the U.S. firm and P is the dollar price

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of the asset.

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(a) Compute the exchange exposure faced by the U.S. firm.

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(b) What is the variance of the dollar price of this asset if the U.S. firm remains unhedged against
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this exposure?
(c) If the U.S. firm hedges against this exposure using the forward contract, what is the variance
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of the dollar value of the hedged position?

aC s
vi y re

Solution:
(a) E(S) = .25(1.20 +1.10+1.00+0.90) = $1.05/€
ed d

E(P) = .25(1,800+1,540+1,300 +1,080) = $1,430

ar stu

Var(S) = .25[(1.20-1.05)2 +(1.10-1.05)2+(1.00-1.05)2+(0.90-1.05)2]

= .0125
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Cov(P,S) = .25[(1,800-1,430)(1.20-1.05) + (1,540-1,430)(1.10-1.05)

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(1,300-1,430)(1.00-1.05) + (1,080-1,430)(0.90-1.05)]
= 30
b = Cov(P,S)/Var(S) = 30/0.0125 = €2,400.
(b) Var(P) = .25[(1,800-1,430)2+(1,540-1,430)2+(1,300-1,430)2+(1,080-1,430)2]
= 72,100($)2.
(c) Var(P) - b2Var(S) = 72,100 - (2,400)2(0.0125) = 100($)2.
This means that most of the volatility of the dollar value of the French asset can be removed
by hedging exchange risk. The hedging can be achieved by selling €2,400 forward.

https://www.coursehero.com/file/14036036/Answer-Key-Additional-Problems-on-Operating-Exposure/
 3. A U.S. firm holds an asset in Great Britain and faces the following scenario:
Probability Spot rate P* P Proceeds Dollar value
from Fwd. of hedged
contract position
State 1 30% $2.20/£ £2,000
State 2 70% $2.00/£ £2,500

(a) Estimate the exposure to exchange rate risk.

(b) Fill in the dollar value of the asset (P) in the table above.
(c) Compute the proceeds from the forward contract if you hedge this exposure.

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Assume the forward rate is $2.05/£. Fill in the proceeds in the appropriate box in

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the table above.

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(d) Compute the dollar value of the hedged position and fill in the blanks in the table
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(e) If you hedge, what is the variance of the dollar value of the hedged position?
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aC s

Solution:
vi y re

Probability Spot rate P* P Proceeds Dollar value

from Fwd. of hedged
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contract position
ar stu

State 1 30% $2.20/£ £2,000 $4400 $450 $4850

State 2 70% $2.00/£ £2,500 $5000 $-150 $4850
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(a) b = - 3000
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(d) Variance is zero.

https://www.coursehero.com/file/14036036/Answer-Key-Additional-Problems-on-Operating-Exposure/

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