Question

Suppose you are a British venture capitalist holding a major stake in an e-commerce start-up

in Silicon Valley. As a British resident, you are concerned with the pound value of your U.S.

equity position. As an economist, you estimate 3 scenarios for the future, as described in the table below:

Scenario	Probability	Forecast exchange rate (£/$)	Forecast asset value (in $)
1	0.2	0.7485	$1,000,000
2	0.4	0.7470	$700,000
3	0.4	0.7451	$500,000

(a) Estimate your exposure to the exchange risk.[6 MARKS]

(b) How would you hedge this exposure? Suppose the forward rate is 0.7460 £/$. Calculate the GBP value of the hedged portfolio under each of the scenarios above [4 MARKS]

IN YOUR CALCULATION, KEEP 4 DECIMAL POINTS FOR THE EXCHANGE RATES, AND NO DECIMAL POINTS FOR CURRENCY NUMBERS.

Answer 1

Ans (a)

Calculation for Table 01

• Cumulative Rate = Probability of Scenario *  Forecast exchange rate (£/$)
• Expected Rate = Sum of Cumulative Rate
• Forecast asset value (in £) = Forecast asset value (in $) * Forecast exchange rate (£/$)
• Cumulative Rate = Probability * Forecast asset value (in £)
• Expected Value = Sum of Cumulative Rate

Calculation for Table 02

• Variance = Sum of [ (Expected Return - Forecast exchange rate (£/$) )^2 * Probability ] in each Scenatio
• Covariance = Sum of [ (Expected Rate - Forecast exchange rate (£/$) ) * (Expected Value - Forecast asset value (in £) ) * Probability ]  in each Scenatio
• Exchange Exposure Risk = Covariance / Variance

Exchange Exposure Risk 1040,39,943 (Ans)

Ans (b)

This exposure can be hedge through :

• Booking future price through forward rate
• Taking exposure in Put Option

forward rate is = 0.7460 £/$

GBP Value in Each Scenario (When Hedge through Forward )

= Forecast asset value (in $) *  forward rate =Forecast asset value (in $) * 0.7460 £/$

Scenario	GBP Value in Each Scenario
1	$7,46,000
2	$5,22,200
3	$3,73,000