Fleur de France has a project that will provide £20 million in revenue in 1 year. The project has a euro cost of €30 million that will be paid in 1 year. The cost of the project is certain, but the future spot exchange rate is not. Assume that there are only two possible future spot exchange rates. Either the spot rate in 1 year will be €1.54/£ with 55% probability, or it will be €1.48/£ with 45% probability. Assume that the French tax rate on positive income is 45%, that a firm’s losses are immediately refunded at a rate of 35%, and that the forward rate of euros per pound equals the expected future spot rate.
a. If Fleur de France chooses not to hedge its foreign exchange risk, what is the expected value of its after-tax income on the unhedged project?
b. If Fleur de France chooses to hedge its foreign exchange risk, what is the expected value of its after-tax income on the hedged project?
c. How much does Fleur de France gain by hedging?