Question

You expect to receive ZAR 1000 000.00 in 3 months time but you are worried about adverse movements (a strengthening dollar) in exchange rates and want to hedge against this,

You gather the following information from the foreign exchange market;

Spot exchange rate $1.7640/ ZAR

Three month forward rate $1.7540/ ZAR

Forecast spot exchange rate three months from now $1.7400/ZAR

Show how you can hedge against the currency risk using a forward contract.

Answer 1

The underlying asset in this case is ZAR which the investor would receive in 3 months time. This implies that the investor is long on the underlying asset and would suffer a loss if the $ price of the asset goes down. In other words, the investor would be hurt by a strengthening dollar. In order to hedge against a strengthening dollar, the investor needs to go short on the forward contract, which basically means that the investor needs to sell a forward contract. This would mean that the investor would forego the freedom to sell the ZAR receivables at the then existing spot exchange rate and instead lock down the forward rate of $ 1.754 / ZAR for the receivables. The hedging procedure will be executed as described below:

- Current Exchange Rate = $ 1.764 and Forward Rate = $ 1.754

- Short Sell 1 million ZAR forward contracts at t= 0 with a maturity of 3-months

- Upon Receiving ZAR 1 million after 3-months, sell the receivables at the then existing spot exchange rate and sqaure off the forwards position by going long (buying) 1 million forwards.The gain/loss in the ZAR position will be offset by a loss/gain in the forards position

- Let us assume that the exchange rate after 3-months becomes $ 1.75

- Loss in Underlying Asset Position =(1.75 - 1.764) x 1000000 = - $ 14000

- Gain in forwards position = (1.754 -1 .75) x 1000000 = $ 4000

As is observable, the forwards position offsets the loss suffered in the spot position atleast partially.