manufacturing firm, Caleb Corp, produces and sells product in its home (US) market, and in a foreign market. There is inherent risk in the revenues collected from the foreign market due to volatility in the exchange rate. Under a benchmark strategy, all of the production takes place in the home country. The resulting expected profits for Caleb Corp are variable, due to variation in the exchange rate. As an approximation, the firm has estimated profits for five possible ranges of the exchange rate, with profit represented as a lottery, L= (.2, 150; .2, 200; .3, 220; .2,250; .1, 270) The probabilities are estimated probabilities for the different ranges. The outcomes in this lottery are the estimated final profit levels (not changes in profit). Now suppose the firm can also buy forward contracts on foreign currency to neutralize the effect of the exchange rate on profits. Assume that these provide complete hedging, but that it involves an additional cost, so that following the financial hedging strategy leads to a degenerate lottery, L= (1,195) That is, for all ranges of the exchange rate, this financial hedging strategy generates 195 in profit. (b) If the CEO is risk averse with utility function u(x)= x.5 over profit, would he prefer the benchmark strategy or the financial hedging strategy? (Hint: use expected utility to compare the two lotteries)
A manufacturing firm, Caleb Corp, produces and sells product in its home (US) market, and in a foreign market. There is inherent risk in the revenues collected from the foreign market due to volatility in the exchange rate. Under a benchmark strategy, all of the production takes place in the home country. The resulting expected profits for Caleb Corp are variable, due to variation in the exchange rate. As an approximation, the firm has estimated profits for five possible ranges of the exchange rate, with profit represented as a lottery,
L= (.2, 150; .2, 200; .3, 220; .2,250; .1, 270)
The probabilities are estimated probabilities for the different ranges. The outcomes in this lottery are the estimated final profit levels (not changes in profit).
Now suppose the firm can also buy forward contracts on foreign currency to neutralize the effect of the exchange rate on profits. Assume that these provide complete hedging, but that it involves an additional cost, so that following the financial hedging strategy leads to a degenerate lottery,
L= (1,195)
That is, for all ranges of the exchange rate, this financial hedging strategy generates 195 in profit.
(b) If the CEO is risk averse with utility
over profit, would he prefer the benchmark strategy or the financial hedging strategy? (Hint: use expected utility to compare the two lotteries)
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