The Current Exchange Rate Is $2/£ $\Delta$ Revenue in £]/[ $\Delta$ Exchange Rate in £/$],
That Is,revenue Change Induced by Exchange

question 86

Essay

The current exchange rate is $2/£.Cookham Industries is a large British firm that exports computer games to the United States.If the dollar depreciates relative to the pound,Cookham will increase the dollar price it charges its U.S.customers.But it cannot raise its U.S.price enough to fully offset any dollar depreciation because if it does so,it will lose customers to its U.S.competitors.Its rule of thumb is that for every $.10/£ increase in the exchange rate (e.g.,from $2.00/£ to $2.10/£)it will increase prices by $5 (e.g.,from $200 to $205 per game).The company will not lower the product price in U.S.dollars if sterling pound depreciates against the U.S.dollar to below $2/£.Given this rule,it will lose only some of its U.S.sales.Suppose its forecast of annual sales in the United States as a function of the dollar price is:
Quantity sold = 50,000 - 100 *price in dollars
Answer the questions below.
a.Plot the British pound value of Cookham's revenue from its U.S.sales as a function of the exchange rate for exchange rates ranging from $1.50/£ to $3.00/£.What is its exchange rate exposure?
b.Suppose each exchange rate scenario in part (a)is equally likely.What would Cookham's expected dollar revenue be? What would be its pound revenue in each scenario if it sold forward that number of U.S.dollars at a forward exchange rate of $2/£? Does this seem like an effective hedge?
c.As an alternative,Cookham calculates the hedge ratio (i.e.,the number of dollars it will sell forward)as
[ $\Delta$ revenue in £]/[ $\Delta$ exchange rate in £/$],
that is,revenue change induced by exchange rate change
Why do you think this hedge ratio performs so much better in offsetting exchange rate risk than the one you calculated in part (b)?

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