Question

An Australian firm uses a forward contract to hedge all of its translation exposure. Assume that the firm overestimated what its foreign earnings would be and assume that the foreign currency appreciated over the year. The firm would generate a transaction loss.

Answer 1

Forward contract is an agreement between two parties so both parties has the obligation. Let’s say the exposure was to yen (JPY). Let’s say the expected earning was 1000,000 Yen and the forward contract was at a price of 70 Yen = 1 AUS dollar.

Now if the earnings are less than the expected, let’s say 800,000 yen and the exchange rate appreciated from the Yen perspective, let’s assume the exchange rate is 65 Yen = 1 AUS dollar

Here there would not be transaction loss from the perspective of Australian dollar because the foreign currency has appreciated so there would be gain on transaction.

For example, at the agreed price of 70 Yen = 1 AUS dollar, for 1000,000 Yen the AUS company would have received = 14285.71 AUS dollar

But since the foreign currency has appreciated at 65 Yen = 1 AUS dollar, you would have received

= (1/65 * 1000,000) = 15,384.62

So, there would not be loss on the transaction even though the earnings expectation has fallen.