Suppose a U.S. firm has an asset in Britain whose local currency price is random. For simplicity, suppose there are only three states of the world and each state is equally likely to occur. The future local currency price of this British asset (P*) as well as the future exchange rate (S) will be determined, depending on the realized state of the world.
State Probability P* S S×P*
1 1/3 £1,000 $1.40/£ $1,400
2 1/3 £1,000 $1.50/£ $1,500
3 1/3 £1,000 $1.60/£ $1,600
Which of the following statements is most correct?
A) The firm faces no exchange rate risk since the local currency price of the asset and the exchange rate are negatively correlated.
B) The firm faces substantial exchange rate risk since the local currency price of the asset and the exchange rate are positively correlated.
C) The firm's exchange rate exposure can be completely hedged with derivatives written on the British pound.
D) Since randomness is involved, no hedging is possible.
