In 2007, an analyst in the derivatives group of investment bank Grenfeld & Co. was asked to devise a hedging strategy for Providence Equity Partners (Providence) in Bell Canada Enterprises (BCE Inc.). Providence was based in the United States and any strategy would involve significant foreign exchange rate risk due to the conversion of returns into U.S. dollars. The analyst needed to consider several long-term hedging strategies that Grenfeld & Co. could recommend to Providence. Her vice-president had asked that she create a hedging strategy by initially assuming a 25 per cent IRR for the investment and its performance, based on two outcomes at the end of the investment (investment horizon = five years): a zero percent IRR and a 25 per cent IRR.

a. Should Providence Capital be worried about exchange rate fluctuations?

b.Assume Providence is successful in restructuring BCE to achieve the 25% IRR in Canadian Dollars. What is the effect of exchange rate fluctuations on Providence Capital's CF (sensitivity analysis)?

c. If the cash flows are hedged using futures or options show how the CF is affected by changes in exchange rates. What happens if the IRR is 25% and the IRR is zero?

d. Based on your findings in (3), would you recommend options strategy or the forwards strategy?