Accounting for Political Risk and the Hedging Decision
Response to the following:
a. Duv Co. (a U.S. firm) is planning to invest $2.5 million in a project in Portugal that will exist for one year. Its required rate of return on this project is 18 percent. It expects to receive cash flows of 2 million euros in one year from this project. The spot rate of the euro in one year is expected to be $1.50. The one-year forward rate of the euro is presently $1.40. Duv Co. wants to account also for the 20 percent probability of a crisis in Portugal. If this crisis occurs, Duv would reduce its expected cash flows to 1 million euros in one year. Duv Co. does not plan to hedge its expected cash flows. Show the distribution of possible outcomes for the project's estimated net present value, including the probability of each possible outcome.
b. Now assume that Duv plans to hedge the cash flows that it believes it will receive if a crisis in Portugal occurs. However, it decides not to hedge additional cash flows that it would receive if the crisis does not occur. Estimate what the net present value of the project will be based on the hedging strategy described here and assuming that a crisis in Portugal does not occur.