RumAbroad Inc. (RA), of which you are the CFO, is a British importer of Caribbean

rum. Its business is to:

1. Collect preorders for exclusive rum bottlings from various distilleries in the Caribbean in GBP in advance. These will be paid by wealthy UK customers upon delivery.

2. Pay for exclusive products in Peso (assume, for simplicity, that all Caribbean rum- producing countries share the same currency) upon release. Rum aging is a long process, and the average time between preorders and delivery is 5 years.

3. Once exclusive products are released, immediately ship them to their UK customers.

Five years from now, RA expects to be able to deliver 10,000 bottles of rum at the average cost per bottle of Peso 5000. Pre-orders are non-refundable, unless RA is unable to deliver the product, and are placed by its UK customers today for the entire expected supply. The average pre-order price is set at GBP 400. Ignore the net working capital, net CapEx, taxes, and all market imperfections, and assume that RA is all-equity financed.

1. Draw the payoff diagram of RAs free cash flow as a function of the GBP/Peso exchange rate .

2. How can RA completely eliminate its exposure to exchange rate risk using forward contracts and secure a constant hedged free cash flow at the level of RAs free cash flow when = 0.05? Assume that the forward price is = 0.05.

3. You suddenly realize that the number of bottles RA can purchase depends on the state of economy in the Caribbean region. 10,000 bottles of rum are only guaranteed if the Caribbean economy is not in a decline and field workers wages denominated in stable currencies are high. Say, 10,000 bottles of rum are only guaranteed if is above 0.05. However, if the Caribbean economy is in a decline, field workers often prefer to switch their job to a more lucrative one (e.g., producing less savory black-market Caribbean exports), slowing down

   production of rum. Say, if is below 0.05, RA can only purchase 10,000 30 450

   bottles. Draw the new payoff diagram of RAs cash flows as a function of

4. You still want to completely eliminate RAs exposure to exchange rate risk. You are therefore thinking of using put and call options as a hedge. Specifically, you want to construct a hedging portfolio that delivers to RA the constant hedged free cash flow of GBP 0.75 million. For partial mark, list a combination of option types (put or call only) and exercise prices that should be in the hedging portfolio. For full mark, provide the exact hedging portfolio. Note: there is no need to think about the price of the hedging portfolio.