Question

A company whose operations (and costs) are located in the United States has most of its sales in the United Kingdom. The company’s managers think the main effect on the pound-dollar rate will be Brexit but there are three possible scenarios: a messy Brexit causes a sharp depreciation of the pound, a post-Brexit investment boom causes an appreciation of the pound, or a delay of Brexit causes the pound-dollar rate to remain stable. a) Which of the three scenarios would be costly to the company? Which would be advantageous? Explain briefly. b) The manager considers the Brexit delay to be the most likely and the Brexit scenario advantageous to the company to be very unlikely. She wants to hedge against the scenario that is costly to the company. Under these circumstances, would futures or options be a better way to hedge? Why is the fact that the advantageous scenario is unlikely relevant to the decision?

Answer 1

During 2016, UK had voted to leave the European Union. Brexit means exit of Britain from the Europan Union. For Financial markets it would have a big impact as UK based firms will lose their passporting rights to conduct business with other countries in the EU, i.e. 27 countries. Since there is no clarity on regulations of the financial markets, this is causing more uncertainty.

A messy Brexit causing sharp depreciation of pound or appreciation or delay of Brexit causes pound-Dollarrate to stabilize. Most costly would be pound depreciating and that would cost revenue of the company to come crashing down. An estimation of revenue and hedging against this crisis should be a wise step to undertake.

Hedging through futures is done to address fluctuations and volatility of the markets. During the voting and revoking of article 50, both time pound has depreciated against $US, hence there has been volatility. Suppose the company knows that it generally sells 50,000 units of its product in UK i the next 6 months. The current spot price of the product is 15 pound per article and the futures price is 13 pound per article. Now the Company would short futures to lock in 13 pound per article and ensures it will receive 13 pounds for every article it will sell. This future contract helps in limiting the risk for the company and doubts about their revenue.