a$)$ Assume that your firm based in Coventry exports medical devices to Italy and receives $1,000,000$ EUR $360$ days from now. You would like to determine whether to hedge this position. You have developed the following scenarios for EUR:

EUR IN $360$ days Probability

$0\mathrm{.}825\%$

$0\mathrm{.}8320\%$

$0\mathrm{.}8425\%$

$0\mathrm{.}8525\%$

$0\mathrm{.}8620\%$

$0\mathrm{.}875\%$

The $360-$day forward rate of EUR is $0\mathrm{.}8420,$ while the current spot rate is $0\mathrm{.}8470.$ Determine the possible differences between the costs of hedging versus no hedging. What is the probability that hedging will be more costly to the firm than not hedging? Determine the expected value of the real cost of hedging and discuss whether you would like to hedge.

b$)$ Current one$-$year interest rates are $1\%$ in Italy and $0\mathrm{.}6\%$ in the UK$.$ Assume the same spot and forward rate from part a$).$ If you decide to hedge using money market instruments, what actions do you need to take and what would be the guaranteed GBP proceeds from the Italian sale? Which financial hedge would you choose: forward hedge or the money market hedge?

c$)$ Give examples of operational hedge of foreign exchange exposure and discuss the potential limitations of financial hedging activity.