Belgium's Android Meta Products NV/SA wishes to hedge its exposure to the exchange rate stemming from its ownership of a marketing affiliate located in UK. This is 1992, and the GBP has just...

Belgium's Android Meta Products NV/SA wishes to hedge its exposure to the exchange rate stemming from its ownership of a marketing affiliate located in UK. This is 1992, and the GBP has just formally joined the ERM after maintaining a constant rate for two years. Still there is risk: what worries Android is that, in the past few years, inflation has been substantially higher in the UK than on the continent, raising the question whether the current exchange rate, BEF/GBP 60, is sustainable. After discussion with its bankers, Android ends up with two possible outcomes:

The UK government may switch to a strongly deflationary policy and stabilize the exchange rate at 60. Such a deflationary policy is expected to depress sales and would decrease the net cash flow of the marketing affiliate to GBP 1.55m.