1. (7pts) In the U.S., firms are subject to progressive corporate tax. Consider XYZ Inc., an exporting firm, which expects to earn $20 million if the dollar depreciates, but only $10 million if the dollar appreciates. Assume that the dollar has an equal chance of appreciating or depreciating, and assume the following corporate tax scheme:

Corporate income tax rate = 15% for the first $15 million.

Corporate income tax rate = 40% for earnings exceeding $15 million

XYZ has two ways to hedge its risky earnings: option market hedge and forward market hedge. Of course, it can also choose not to hedge at all.

1. (2pt) Calculate the expected tax of XYZ under the above tax scheme when it does not hedge.
2. (2pt) By hedging with options, XYZ expects to earn $17 million if the dollar depreciates, and to earn $13 million if the dollar appreciates. Calculate the expected tax of XYZ with an option market hedge.
3. (2pt) By hedging with forwards, XYZ expects to earn $15 million regardless of the changes in the dollar exchange rate. Calculate the expected tax of XYZ with a forward market hedge.
4. (1pt) Comment on the strategy (whether to hedge; if hedge, which way) that XYZ should adopt.