Question

How spot rate and forward rate affects the annual cash flow? Also the importance of hedging too?

Answer 1

Spot rate is the rate at which the exchange of currency takes place in the forex market.

For example let say I have $1000 and I want to get Euros with whatever dollar i have then to get the Euro's instantly , i can go to the forex market and see at what rates banks are selling Euros to me. The rate at which on the spot exchange takes place is called spot rate.

Forward rates are the exchange rates 1 month,3 months, 6 months down the line based on the interest rate of two different countries based interest rate parity.

Now how do they affect annual cash flow: Suppose I have a receivable worth $1MM 6 months down the line but my company is located in UK and my fuctional currency is in Euro. So as you can see, for me operating/functional currency is Euro. But my partner is giving me receiavable in $. Now let's say the spot exchange rate is 1.1USD/EURO which says 1 EURO=$1.1.

At this spot rate if I carry out the transaction : i will get 10^6/1.1= 909091 EUROs , if the 3 months forward rate is

1.7 USD/EURO then my total receivable in EURO is 10^6/1.7 =588235.3 Euros. Can you spot the difference, Its better to get the transaction done at Spot rate rather than waiting for 3 months forward. But then my receivabale I will be getting 6 months down the line and to avoid so much of fluctuation because of volatility of forex markets , its better to hedge the risk. Hedging is the process of reducing or negating the impact of foreign exchnage rate volatility.

It can be done via: Forward Contracts ,Money Market Hedge , Options Hedging ,Futures.