Question

A U.S. company expects to have to pay 10 million Mexican pesos in six months. Explain how the exchange rate risk can be hedged using (a) a forward contract and (b) an option.

Answer 1

In this question a U.S company expects that it have to pay 10 million Mexican pesos in six months. But it afraids of the fact that suppose after six months exchange rates between U.S. currency ($) and mexican pesos will not be same as of today. Suppose if US $ falls against mexican pesos then it have to pay more after 6 months. This is popularly knowns as currency exchange rate risk. Now U.S company want to hedge this risk through derivates i.e. forward contract or an option contract.

(a) Hedging through a Forward Contract:

Forward contract is a type of derivate contract between two parties specifying the amount, date and rate for currency exchange in future. Exchange rate for the future will be decided today itself and parties will be able to exchange the currency in the future at the rate which is fixed today.

In the given case U.S. company will enter into a forward contract with some local bank fixing the six month's later exchange rate for U.S. $ and mexican pesos today itself. U.S company will enter the contract in such a way that it after 6 months it will be able to make the payment of 10 million mexican pesos. Suppose U.S company today signs a forward contract with local bank to receive 10 million mexican pesos after 6 months and exchange rate decided today is 20 mexican pesos in 1 $ then after 6 months suppose exchange rate is 17 mexican pesos per $ then U.S. still receives 20 mexican pesos per Dollar. In this way U.S company can hedge the currency exchange rate risk through a forward contract.

(b) Hedging through an Option :

Option contract is a derivative that derives its value from the underlying asset. In this case underlying asset is mexican pesos. Generally there is two options in the options derivative, first is call option and second one is put option. Lets discuss both one by one:

Call option: It gives a right to the option holder to buy the particular currency at a certain exchange rate.

Put option: It gives a right to the option holder to sell the particular currency at a certain exchange rate.

In the give case U.S company needs 10 million mexican pesos after 6 months but afraid of changing exchange rates. Therefore company can buy the 6 month's later call option of mexican pesos so that if the exchange rate changes after 6 months and it will need to pay more then it would be able to get the required 10 million mexican pesos at certain exchange rate and can hedge the exchange rate risk. Generally options comes in lots. For eg : Currency options consists of lot of 100000 units. Therefore Company needs to buy 10 lots mexican pesos call option.

In this way U.S. company can hedge the currency exhange rate risk through the forward contract or an option contract.