Question
JP Morgan is a broker for frozen seafood products for Bar Harbor Lobster, Inc. JP Morgan just signed a deal with a Belgian distributor. Under
JP Morgan is a broker for frozen seafood products for Bar Harbor Lobster, Inc. JP Morgan just signed a deal with a Belgian distributor. Under the terms of the contract, in one year JP Morgan will deliver 4000 kilograms of frozen lobster for 100,000 euros. JP Morgan's cost for obtaining the lobster is $110,000. All cash flows occur in exactly one year. All profit or loss will be quoted in $.
1. Calculate the total unhedged profit or loss in one year from the contract if the spot exchange rate in one year will be $1.50/euro.
2. Suppose the one-year forward exchange rate is $1.25/euro and that JP Morgan enters a forward contract. Does JP Morgan need a long or short position on euros? What is the total profit or loss?
3. Suppose that instead of using a forward contract, JP Morgan considers using options. A one-year call option to buy euros at a strike price of $1.25/euro is trading for $0.10/euro. Similarly, a one-year put option to sell euros at a strike price of $1.25/euro is trading for $0.10/euro. To hedge the risk of the contract, should JP Morgan buy or sell the call or the put option on euro?
4. Suppose the spot exchange rate in one year will be $1.10/euro. According to the option hedge in Question #3 above, what is the net profit or loss?
5. Suppose that by the end of the year, a trade war erupts, leading to a European embargo on U.S. food products. As a result, the deal is canceled, and JP Morgan doesn't receive the euros or incur the costs of procuring the lobster. However, JP Morgan still has the profits (or losses) associated with the forward or options contracts above. When there is a risk of cancellation, which type of hedge has the least downside risk?
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