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Scenario: Jim Logan, the owner of an American based small business, Sports Exports, Inc., specializes in exporting footballs to Great Britain. In return, he receives payments in British pounds every month which need to be converted into dollars. He has noticed that the exchange rate between the dollar and the pound at the time of exchange every month is significantly affecting his profits. Since he is a small business owner and not a foreign currency expert, he has hired your consulting firm to advise him with respect to the following matters below.
Now, Mr. Logan is questioning whether this process is worth the trouble. He suggests that if the international Fisher effect (IFE) holds, the pound's value should change (on average) by an amount that reflects the differential between the interest rates of the two countries of concern. Because the forward premium reflects the same interest rate differential, the results from hedging should equal the results from not hedging on average.
1. Is Logan's interpretation of the IFE theory correct? Why?
2. If you were in Logan's position, would you spend time trying to decide whether to hedge the receivables each month, or do you believe that the results would be the same (on average) whether you hedge or not?
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