Question

Prime Emerald Inc. is an upscale rug manufacturer in Flint, Michigan, that just developed a deal with a major high-end gallery in Italy to display their rugs over the course of one year. The rugs are supposed to be shipped by 08/15 and arrive no later than 9/15. The Gallery is willing to front the expenses of the rugs transition to Milan, Italy, and the company within five days will receive payment of 500,000 euros. It is expected that 100,000 of the euros will appreciate substantially on 9/25. Unfortunately the rugs have been delayed and it will take another month to receive them. 1. Explain how Prime Emerald Inc. can hedge the current position with Italy. a. Explain the hedging positions under each currency derivative including forward contracts, future contract and options contract. 2. Explain the potential risks and losses by waiting another month to see if the rugs make it before they decide to hedge?

Answer 1

1. In order to hedge the current position with Italy, it is worth considering the currency forward and as a part of which Prime Emerald will sell Euros and buy USD. And the price of forward contract is fixed today adn hence and any adverse movement in the currency can be hedged. Any downward movement (Euro appreciation and USD depreciation) will result in profit in forward contract and loss in spot position and hence net zero.

2. a) Forward contract - customized contract with contract specifications call upon by parties. No daily settlement. only on maturity. Counterparty default risk if not CCP cleared.

b) Future contract - standarized contract with daily mark to market. Initial margin is requried to be put by each party with exchange. No counterparty default risk.

c) Options contract - To buy the contract, premium is paid and exchange settled so no counterparty risk.

3) Without hedge, the potential risk is of Euro appreciation against USD and party receiving Euro will have resulting loss owing to this adverse currency movement.