Question

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?

Answer 1

a. To completely hedge this exposure, we will need to hedge both the currency exposure as well as the oil price exposure. To do that, we will take a long position in Euro forward or future or buy a call in Euro so that we receive Euro at a fixed price which has been fixed now itself. Apart from this, to hedge the oil price risk, we will buy oil futures or forwards or call option so that even if the price goes up, we will be protected because of this hedge.

b. Suppose if scenario 3 materializes after 3 months, it would cost us very much to buy the oil with the contract we had in place from our supplier. But, since we already had the hedge in place, i.e. had the forward/future/call option, the increase in price will give us profits there. Hence, our effective buying price will come out to be what we fixed in the hedge. Therefore, we need not be worried about the oil price movement and the different scenarios.