You are a sales representative of an Estonian company that exports local mushrooms to United Kingdom. Under the terms of the contract, in one year you will deliver 40 tons (=50 000kg) of mushrooms for 4.5 pounds a kilogram. Your cost of obtaining mushrooms from the mushroom pickers from Vrumaa County is 2.50 EUR per kilogram. You may assume that all cash flows occur in exactly one year.

Questions:

a) explain the exchange rate risk here and how this risk can be mitigated with forward contract?

b) compute the theoretical one year forward exchange rate if UK interest rate is 2.5% and EUR interest rate is 1.25%

c) Compute the hedged profit from the transaction in euros.