Question

The Wolfpack Corp. is a U.S. exporter that invoices its exports to the United Kingdom in British pounds. If it expects that the pound will depreciate against the dollar in the future, explain to Wolfpack Corp. how a forward contract and an option contract can help hedge its cash flows that are received in foreign currency.

Answer 1

Let us understand this question from very basic level with an example.

Assuming the current exchange rate of GBP/USD is 1.25, we can formulate that

100 GBP = 125 USD (GBP = Great Britain Pound, USD = Unites States Dollar)

After the currency depreciate, the rate will go down to 1.20 (assumed). So, future conversion is

100 GBP = 120 USD

This basically means that The Wolfpack Corp. will be receiving more GBP (100/120 > 100/125) than earlier when received as cash flows in foreign currency. In short, USD has appreciated and will be fetching less USD for the same volume of trade done earlier, which indeed is a risky phenomenon.

To mitigate the same, one can go into a forward contract, wherein one can enter into a private agreement at a predetermined price (in this case its exchange rate) for the future date of upto 12 months, thereby avoiding any risk of depreciation of GBP.

But in case,GBP appreciates reducing the value of USD, One can enter into a Option Contract (mainly call option i.e. buy side)for a future period of 3 to 6 months of contract and hedge the position by going for a call option of GBP.

Thus, irrespective of the currency appreciate or depreciate, The wolfpack Corp. can trade with United Kingdom without worrying much about currency movement by hedging their exchange with the method opted above.