SMALL FIRMS LOOK TO DERIVATIVES TRADING TO MANAGE COSTS
Karl Fowler isn’t a traditional publisher. His books, which chronicle major sporting events and teams, can weigh more than 90 pounds and go for as much as $4,000. So to control the costs of the raw materials Mr. Fowler needs to produce these hefty tomes, the entrepreneur is using an equally untraditional approach for small businesses: derivatives trading.
These sophisticated financial instruments—which allow investors to hedge risks and bet on fluctuations in anything from (he weather to orange-juice prices—might not seem relevant to a small book publisher. But Mr. Fowler cut his teeth as a derivatives trader. So when he left the finance world in 2002 for book publishing, it was only natural for him to apply his specialty to help insulate his British firm, Kraken Group, (rom rising prices for raw materials like paper, ink, and silk....

Required:
1. One strategy used by Kraken Group is to buy pulp-paper futures on commodities exchanges. Paper prices can go up and down by more than 10% in a short period. When paper prices increase, Kraken’s operating profits fall. Explain how pulp-paper futures can be used to protect Kraken’s profits from harmful paper price increases.
2. How will the pulp-paper futures affect profits if paper prices instead decline?
3. Ink prices tend to be even more volatile than paper prices but cannot be hedged by exchange-traded futures. So, Mr. Fowler asked an ink supplier to set up a forward contract for about half of the amount purchased each year. Explain how a forward contract can be used to protect Kraken’s profits from harmful ink price increases.
4. How will the forward contract affect profits if ink prices instead decline?