Question

The current exchange rate is 1.50 $/€, and 3-month forward exchange rate is 1.55 $/€. The 3-month interest rate in US is 5%, and the 3-month interest rate in France is 3%. Assume you are a trade who demands 1 million Euro in 3 months.
2. Please explain the foreign exchange rate risk that you face. (no more than 100 words)

3. Please describe how to use the forward contract to hedge the risk. (no more than 100 words)

4. Please describe how to use the futures contract to hedge the risk. (no more than 100 words)

5. Please describe how to use the option contract to hedge the risk. (no more than 100 words)

Answer 1

2) The foreign exchange risk is the risk that at the time you need the funds the exchange rate of dollar vs Euro, would be unfavorable to you and you would have to pay more for that. Let’s say for example your domestic currency is dollar but you need 1 Million Euro, the current exchange rate is 1.50 Dollar for 1 Euro, and at the time when you require the funds in Euro, the exchange rate might be 1.55 Dollar per euro or 1.60 Dollar per Euro and you are paying more for one Euro then what you would have paid sometimes back.

3) The forward contract is a private agreement between two parties where they agree to enter into a transaction for a certain amount at certain price on a certain date. Here you can simply buy the forward contract at 1.55 dollar per Euro and for that you have to pay certain commission and at the end of 3 month you can convert dollar into euro at the 1.55 dollar per euro, No matter what the price movement is. The benefit of this is you are getting a fixed rate at which you can convert but there is counterparty risk of default, that other party might not fulfill the obligation.

4) The future contract is similar to forward but it is more standardized form rather than private agreement between two parties. You can buy a future contract for 3 months at certain price, let’s say at 1.55 dollar per euro and at the end of 3 month you can convert dollar into euro. The benefit of futures over the forward is they are traded on the exchange are there is very little to none counterparty risk because there is mark to market daily settlement. Daily settlement makes sure that the default is least. The only issue of futures is they are standardized form so they are traded in fixed multiples.

5) Option gives you the right to exercise the contract if your position is favorable to you and do not exercise it if it is not favorable to you. You can buy call option on the dollar vs Euro where you enter into an agreement with a strike price of 1.55 dollar per Euro, for this there is some premium that you have to pay. At the end of the contract if the price is above 1.55 then you can execute the contract and if the price is below the 1.55 then you can buy it from the market. This is an advantage of options.