Question

Explain how the forward exchange rate can be used for hedging using the forward exchange market. Use realistic numerical examples to illustrate your answer. Use the dollar per euro exchange rate as the basis for your answer.

Answer 1

Currency Forward contract is a contract where by one party enter into transaction with another party to buy or sale one currency at a stated price for another currency on a specifid date .

Both party has to honer this agreement only on specific agreed date at the time of entering into forward contract .

There exist risk in international forex market due to volatility in currency . A firm has base currency but can have exposure to multiple currency due to its international operation . In order to hedge its Cash flow receivable or Cash flow payable in different currency firm can enter into forward rate contract and eliminate this risk.

Example : Suppose AB corporation is US based firm selling laptop to UK and has receivable of Euro 1 million after 3 month . Current spot rate is $1.5/Euro . AB corporation is afraid of $ appreciation vs Euro. Forward contract is available at rate of $1.45/Euro for 3 year period.

AB corporation can use hedging here by entering into forward contract today to exchange Euro 1 million at exchange rate of $1.45/Euro . Hence, entire currency movement risk can be eliminated .