CORPORATE FINANCE- RISK MANAGEMENT

You manage a Swedish company that produces hats. You source your textiles mainly from Poland. The next input delivery from Poland is coming in three months. The supplier requires payment in Euros.

a) What is the upside risk/downside risk to your company that arises from the international nature of the transaction?

b) Briefly elaborate on at least two different ways you could hedge this risk using derivatives? What are the advantages and disadvantages of each strategy?

c) Assume you do not have access to derivatives markets. How could you still hedge the risk? Why is it preferable to have access to derivatives markets and use derivatives to hedge?

Assume the expected input costs are 2 million SKK. If you do not hedge, those costs might rise to 2.6 million SKK or fall to 1.4 million SKK. Increase or decline in costs occurs with equal probability. You could buy a derivative today that eliminates all risk, that is the derivative locks in the costs at 2 million SKK for sure. At these costs of 2 million SKK your profits would be 0.6 million SKK. The derivative costs 0.1 million SKK.

d) Would you buy the derivative? Argue with help of a decision tree.