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 80 tons (=80 000kg) of mushrooms for 2.8 pounds a kilogram. Your cost of obtaining mushrooms from the mushroom pickers from Vrumaa County is 3.40 EUR per kilogram. You may assume that all cash flows occur in exactly one year.

a. 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 0.50 EUR/GBP to 0.80 EUR/GBP (with increments of 0.10 euros). Label this line Unhedged Profits. Explain carefully the exposure to exchange rate risk.

b. Suppose that the current one-year forward exchange rate is 0.7 EUR/GBP 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.

c. Compare and explain your result from b. with the result from a.