Companies based in the United States that operate in foreign nations must convert currencies in order to pay obligations denoted in those currencies. Consider a company that has a contract that requires it to pay 1,000,000 Venezuelan bolivars for an oil shipment in six months. Because of economic uncertainties, managers at the company are unsure of the future exchange rate. Local contacts indicate that the exchange rate in six months could be 2.15 bolivars per dollar (with probability 0.6) or might rise dramatically to 5 bolivars per dollar (with probability 0.4).
(a) If managers accept these estimates, what is the expected value today, in dollars, of this contract?
(b) The expected value of the exchange rate is 2.15(0.6) + 5(0.4) = 3.29 bolivars/dollar. If we divide 1,000,000 by 3.29, do we get the answer found in part (a)? Explain why or why not.