Question

Question 8

Lothbrok Industries (based in Canada) will be importing USD 2.5 million worth of goods in four months. In order to make the sale, Lothbrok will be paying in US dollars in four months time. The following exchange rate information is available:

Spot price: 1.351 CAD = 1 USD
Four- month forward rate: 1.362 CAD = 1 USD

Why might Lothbrok wish to hedge their currency risk? How can they do so using a forward contract? No calculations required. Briefly explain.

Question 9

Refer to information provided in question 8. If the spot exchange rate in four months is 1.376 CAD per USD, calculate Lothbrok's profit or loss if they did hedge their currency risk.

Answer 1

8.Lothbrok industries ( Canada Company ) is importing the goods and it is required tot pay the amount in U.S Dollors after 4 months time.There is higher risk asscoiated in foreign transactions, no one knows what is the exact foreign exchange rate for the currencies involved.So the buyer is having the fear the canadian dollor may fall down ( that means U.S Dollar currency rises up).If this happens, then the buyer is required to pay more U.S Dollor to settle the amount. In order to avoid this loss, the buyer may hedge his risk by entering into the forward contract.

In the forward contract , the currency exchange rate isfixed

For example spot price : 1.351CAD = 1 USD

Four months forward rate: 1.362 CAD = 1 USD

If the FRA is entered , then the buyer liability is fixed. Irrespective of the currency exchange rate on settlement date, he simply buy from the forward contract and pay the amount. So the buyer need not worry about their exchange rate,by predefing his liability through forward contract

Conclusinon: If on the settlement date, if the USD raises up than buyer will be benefied, if it falls, the seller would loose by entering into the FRA.

9. spot price: 1.351 CAD = 1 USD

Four months FRA : 1.362 CAD = 1 USD

Settlement date ( Spot) : 1.376CAD = 1 USD

If the company does not enter into a FRA Transaction, then the following computed amount has to be paid on the settlement date

1.376 CAD = 1 USD

2500000*1.376= 2500000USD

2500000USD =34,40000 CAD

The company enters into the FRA contract, so the amount to be settled is

1.362 CAD = 1 USD

1.362*2500000CAD = 2500000USD

3405000 CAD= 2500000 USD

Net savings available to the company due to entering into the FRA Contract is

= 34,40000CAD-3405000CAD

= 35000CAD

so the company is benefited by 25000 CAD by entering into the Forward contract transaction.