0. 1. (Hedging) You are a sales representative of an Estonian trading company that exports mushrooms to United Kingdom. Under the terms of the contract, in one year you will deliver 90 tons (=90 000kg) of mushrooms for 2.8 pounds a kilogram. Your cost of obtaining mushrooms from the mushroom pickers from Vrumaa County is 3.50 EUR per kilogram. You may assume that all cash flows occur in exactly one year.
1. Plot (in a graph) your profits in euros from the contract as a function of the exchange rate in one year, for exchange rates from 0.60 EUR/GBP to 0.90 EUR/GBP (with increments of 0.10 pounds). Label this line Unhedged Profits. Explain carefully the exposure to exchange rate risk.
2. Suppose that the current one-year forward exchange rate is 0.7 EUR/GBP (or 1/0.7 = 1.4286 euros per one pound) and you consider setting up a forward hedge. Please explain how exactly would you set up the hedge and plot your combined profits from the contract and the forward contract as a function of the exchange rate in one year. Label this line Forward Hedge.
3. There is also a possibility to hedge using options. A one-year call option to buy euros (and sell pounds) at a strike price of 0.70EUR/GBP is trading at 0.07 EUR (eight euro cents per pound). Similarly, a one year put option to sell euros (and buy pounds) at a strike price of 0.70 EUR/GBP is trading at 0.06 EUR. To hedge the risk of your profits (in euros), what should be your preferred strategy? Compute your profits and update your graph by adding another line for combined profits with option hedge. Label this line Option hedge
4. Compare and explain your result from b. and c. with the result from a. Please explain, in which situations may option hedge be preferred to forward hedge?