ABC Pharmaceuticals has a subsidiary in the U.K. that generates revenues and expenses in British pounds. At the end of each fiscal year, ABC converts excess cash flow from the subsidiary into US dollars to fund its R&D (located in the US) for the next year. The firm expects the subsidiary will generate about 120 million this year. Suppose the current spot rate for the pound is $1.615 and the December forward price is $1.604. Suppose that options are available with a strike of $1.60. At that strike, the call premium is $0.0208 and the put premium is $0.0129. a. How can ABC insure against insufficient R&D funds? Draw the risk profile and options hedging strategy. b. What is the firms dollar cash flow if the spot rate on the pound rises to $1.65 by December and it has hedged with options? What minimum dollar cash flow will it generate using options hedging? c. What (guaranteed) dollar cash flow will result if the firm hedges with a forward contract instead of options? d. Suppose calls with a strike of $1.70 are available for $.0152 and puts with a strike of $1.50 are available for $0.0118. What collar strategy could the firm employ with these options and what range of cash flows would result?

Suppose that the pharmaceutical firm in the previous problem faces quantity risk as well as FX risk because it is not sure how many pounds will be generated by the subsidiary. Suppose they entered into a contract on the notional principal of 120 million, but the actual cash flow turned out to be 80 million. a. If they entered into a forward contract, what is their dollar cash flow in the event the exchange rate ends up being $1.55? If it ends up being $1.65? b. If they have, instead, entered into an option contract, what is their dollar cash flow in the event the December exchange rate ends up being $1.55? If it ends up being $1.65?