The current exchange rate is USD2 = GBP1. ClickEasy is a large British firm that exports computer games to the United States. If the dollar depreciates relative to the pound, ClickEasy 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-cent increase in the exchange rate (e.g., from USD2 = GBP1 to USD2.10 = GBP1), it will increase prices by $5 (e.g., from $200 to $205 per game). 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 = 1,000,000 − 100 × price in dollars
Answer the following questions:
a. Plot the British pound value of ClickEasy's revenue from its U.S. sales as a function of the exchange rate for exchange rates ranging from USD1.50 = GBP1 to USD3.00 = GBP1. What is its exchange rate exposure?
b. Suppose each exchange rate scenario in part (a) is equally likely. What would ClickEasy'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 USD2 = GBP1? Does this seem like an effective hedge?