Question

RL Company is a Hong Kong-based company and purchases the raw materials from Germany. RL will settle the payment of the materials in six months. This payment will be in Euro, RL plans to hedge against a rise in the value of the Euro over the next six months. The spot rate of the Euro is HK$ 8.55. The HK interest rate is 1.5%, and the Euro interest rate is 4.5%. Presume that interest rates remain fixed over the coming six months. Assume that 360 days for a year.

(a) How can RL Company use a forward contract to hedge any possible exchange rate risk?

(b) Estimate the no-arbitrage price at which RL Company could enter into a forward which expire in six months.

(c) After 60 days when RL Company entered into the forward contract. The spot rate is HK$8.10. Assume the interest rates remain fixed, update the value of RL Company’s forward position. Also, decide whether RL Company short or long the forward contract.

Answer 1

(a) RL company needs to pay its German raw material supplier in Euros after 6 months. This implies that RL company is short on the underlying asset (euros in this case) at the moment and hence in order to hedge against the risk of an appreciating Euro, needs to go long in the forwards market. Hence, the company will purchase a 6-month maturity forward contract to purchase Euros at a fixed forward rate 6 months from now.

(b) The no-arbitrage price will be calculated using the covered interest rate parity, as shown below:

Hong Kong Interest rate = 1.5% per annum, Euro Interest rate = 4.5 % per annum and Current Spot Rate = HK $ 8.55 per euro

Therefore, Forward Rate = [1.0075 / 1.0225] x 8.55 = HK $ 8.425 / Euro

(c) Remaining Tenure of the Forward Contract = 180 - 60 = 120 days or 4 months

Therefore, new forward rate = 8.10 x [1.005 / 1.015] = HK $ 8.0202 / Euro

The company is still short on the underlying asset (euros) and therefore a suitable hedge would involve going long on the forward contract.