S. H. Products, located in central England close to the Welsh border, is an old-line producer of herbal teas, seasonings, and medicines. Its products are marketed all over the United Kingdom and in many parts of continental Europe as well.

S. H. generally invoices in British pound sterling when it sells to foreign customers in order to guard against adverse exchange rate changes. Nevertheless, the firm has just received an order from a large wholesaler in central France for 320,000 of its products, conditional upon delivery being made in three months' time and the order is invoiced in euros.

S. H.'s controller, Edward Pauls, is concerned with whether the pound will appreciate versus the euro over the next three months, thus eliminating all or most of the profit when the euro receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the firm's banker for suggestions about hedging the exchange rate exposure. Mr. Pauls learns from the banker that the current spot exchange rate for / is 1.4537, thus the invoice amount should be 465,184.

Mr. Pauls also learns that the three-month forward rates for the pound and the euro versus the U.S. dollar are $1.8990/1.00 and $1.3154/1.00, respectively. The banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the / forward crossexchange rate implicit in the forward rates against the dollar.

Suppose S. H sells at a twenty percent markup.

What would you do if you were Mr. Pauls? Construct the hedging framework for Mr. Pauls and advice the best solution for S. H. Products.

(10 marks)

b. Suppose that the current spot exchange rate is 1.50/ and the one-year forward exchange rate is 1.58/. The one-year interest rate is 6.0% in euros and 5.2% in pounds. You can borrow at most 1,000,000 or the equivalent pound amount, i.e., 666,667, at the current spot exchange rate. i. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit.