Problem -

Kevin Gmbh, a company based in Germany, has received today, 7 June 2014, an order to sell 12,000 tons of fertilizer to a client based in Chicago, USA.

Kevin's production cost is 280 Euro per ton of fertilizer, and it usually makes a 25% gross margin on its sale.

The invoice to the client needs to be issued today, but will be payable on 7 November 2014. Moreover, although Kevin's base currency is Euro (EUR), the client only pays in US Dollars (USD) and wants to be invoiced in this currency.

While today 1 EUR = 1.35 USD, Kevin's treasurer knows that by the time he is paid by his American client, the EUR/USD rate could be very different, either up or down from the current level, exposing him to a potential foreign exchange loss. Therefore, he thinks that a hedge is necessary, but is hesitating between a forward contract, a currency futures contract, and an option.

The prices of the currency futures contracts could easily be found on Bloomberg.

On the other hand, Kevin's home bank, Commerzbank, has offered the following quotes, and has the necessary internal authorizations to trade with Kevin Gmbh.

(a) What is the amount of the invoice issued to the client?

(b) What is the risk for Kevin Gmbh on this transaction?

(c) Between a currency forward and a currency futures contract, which one would offer Kevin the best hedge and why?

(d) Describe a call option and a put option.

(e) Describe the transaction that Kevin Gmbh should enter in each of the two hedging strategies offered to him by Commerzbank (forward and option).

(4 marks)

(f) Compute the proceeds Kevin will receive in the three different strategies offered (forward, option, "do nothing" or "no hedge"). Assume EUR/USD on 7 November is actually 1.25, 1.35 and 1.45.