Farndale plc is a UK supermarket chain with subsidiaries in a number of different countries.
Some years ago, the business entered the US market but the financial results proved to be disappointing. As a result, the business recently agreed to sell its US stores to a rival US supermarket chain for $250 million. An initial payment of $100 million has already been received and the balance is due to be received in three months’ time.
The directors of Farndale plc have to decide whether, and if so, how, to hedge against the foreign exchange risk arising from this balancing payment. They are considering three possible options:

(i) To take out a forward exchange contract. Exchange rates are:

(ii) To take out a currency option. A bank has offered an option at an exercise price of £1 = $1.30 and at a premium cost of £1.10 per $100.
(iii) To do nothing.

Required:

(a) Show the effect of each of the three options being considered, assuming that the exchange rate has moved in three months’ time to:

(i) £1 = $1.35 

(ii) £1 = $1.20

(b) Discuss the results in (a) above.

Transcribed Image Text:

£/$ spot 1.2806-1.2852 £/$3-months forward 1.2724-1.2780