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Suppose you are an importer of olive oil from Greece to the Switzerland. You are preparing...

Suppose you are an importer of olive oil from Greece to the Switzerland. You are preparing to import an olive oil shipment of 100,000 lbs that will require payment in Euro (€) in 3 months. The payment’s exact amount will depend on both the CHF/€ exchange rate, as well as the price for oil, which is a function of uncertain supply conditions in Greece. You project the following six scenarios with regards to the price of olive oil in 3 months:

Scenario Price (€/lb of oil)

1 2.1

2 2.3

3 3.8

4 1.8

5 3.0

6 2.8

a) What can you do today if your goal is to completely hedge this €-exposure?

b) Suppose that 3 months from now, scenario # 3 materializes. What will you do?

Solutions

Expert Solution

Here the importer imports olive oil from greece to switzerland. The importer has to pay for 100000 lbs of oil after 3 months in Euro. So, currently he has an exchange fluctuation risk that is value of CHF against Euro. During this 3 month period, if the value of CHF increses against Euro, then the importer will be paying less. As against the case, if the CHF value decreases against Euro, then the importer has to pay more in the future. In order to completely hedge this rsik, the importer can enter into 3 months forward buy Euro contract at 3 months forward price as determined today. In such case his exposure to risk is mitigated as he is paying only the forward price as decided today after 3 months.

Another thing he can do is to hold 3 month call option. In such a case, if the spot price is more than the exercise price, his loss can be mitigted from the options. At even the worst case, maximum amount he has to pay is the exercise price plus commission.

b) If the 3 month spot price happens to be 3.8:

If he enters into forward contract, this won't affect his cashflow as he is going to buy Euro only at forward price as decided on the date on entering into forward contract.

If he enters into options, then he has to check if the exercise price is more than 3.8 or vice versa. If the exercise price lore thn 3.8, then he has to buy at 3.8 and allow the option to lapse. If the exercise price of the option is less than 3.8, then he can exercise the option.   

ekkarill92 answered 2 years ago
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