Question

Company A sold a super computer to the SAP Institute in Berlin on credit and invoiced €10 million payable in 3months. Currently, the 3-month forward exchange rate is $1.30/€ and the foreign exchange advisor for Company A predicts that the spot rate is likely to be $1.25/€ in 3months.

(1)What is the expected gain/loss from the forward hedging?

(2)If you were the financial manager of Company A, would you recommend hedging this euro receivable? Why or why not?

(3)Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not?

(4) Suppose now that the future spot exchange rate is forecast to be $1.42/€. Would you recommend hedging? Why or why not?

Answer 1

(1) Since the forward rate is higher than the spot rate

Expected gain = $(1.30-1.25)*10,000,000 = $500,000

(2) The spot rate after 3-months is expected to be the same. At the same time, the forward rate is higher than the current spot rate.

Hence, I would recommend hedging this Euro receivable. This is because the expected gain due to the forward contract is $500,000 as calculated in part 1). Also, any exchange rate risk would be hedged.

(3) Yes, I would still recommend hedging.

The expected gain/loss, if the future spot rate be the same as the forward exchange rate quoted today, will be 0.

However, the entire exchange rate risk of Company A would be hedged, hence I would recommend hedging.

(4) In this case, the expected loss to Company A due to hedging is:

Expected loss = $(1.30-1.42)*10,000,000 = -$1,200,000

Here, I would not recommend because the expected loss is too high. However, If Company's A management is too conservative, then hedging should be done, as hedging eliminates any foreign exchange risk.