Question

Consider yourself as a manger of a United States company. Your company expects to receive 1 million Euros in six months.  Explain how the exchange rate risk can be hedged using (1) a forward contract; (2) a futures contract and (3) an option.

Answer 1

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company.

In our example we have Euro 1m receivable in 6 month our base currency is USD . We have risk of USD appreciation against the Euro .

Hedging through –

1. Forward Contract : The Forward Contract is an agreement between two parties wherein they agree to buy or sell the underlying asset at a predetermined future date and a price specified today. The Forward contracts are the most common way of hedging the foreign currency risk. rate in the forward market is the rate which has been fixed today or at the time the transaction is agreed to but the actual delivery takes place at a specified date in the future. Thus, forward currency contracts enable the parties to the contract to lock the exchange rate today, to buy or sell the currency on the predefined future date.

In our case we can enter into forward market contract to sale $1m for USD at a mutually agreed exchange rate now itself for payment after 6 month. Also no cash outflow required at the time of agreement only after 6 month cash flow will be exchanged between counter party .

1. This is prefect hedge & completely reduce rate change volatility
2. No cash outflow required at the beginning of the agreement
3. No transaction cost required
4. Risk of counter party default

1. Futures contract : Futures contracts give the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. Future contract are standardized. In our case we can buy USD currency future to sale for Euro 1m . Currency future contract are exchange traded and available in standard lot size .
   1. 1) Counter party default risk is low as we have exchange
   2. 2) May not be fully hedged due to standard contract which may not be available in out required volume
   3. 3) Expiry : Future contract have expiry and we may need to roll over till 6 month for which we also may need to incur transaction cost again and again

c)Option Contract : A currency option is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller, the amount of which varies depending on the number of contracts if the option is bought on an exchange, or on the nominal amount of the option if it is done on the over-the-counter market. Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.

In our case we can buy USD currency put option against Euro for 1m Euro to hedge our position .

1. 1) Counter party default risk is low as we have exchange
2. 2) May not be fully hedged due to standard contract which may not be available in out required volume
3. 3) Expiry : Future contract have expiry and we may need to roll over till 6 month for which we also may need to incur transaction cost again and again