Question

The eurocurrency market can be used effectively to hedge against the anticipated appreciation and depreciation of a currency (hint. Consider an example). Describe these processes - for appreciation & depreciation briefly. You can use a diagram or simply describe the steps.

Answer 1

Eurocurrency market means the money market for a currency outside the country where it can used as a legal tender of money. It should not be confused as a market for EU or EURO denominated currencies. This eurocurrency market can be effectively used to hedge the currency risk of future foreign currency receivables or payables. Let us take an example to understand this: Trader A from India sold goods worth 1000$ to Customer B in the USA. Payment for the same is required to be made at the end of 1 year. Assume that the current exchange rate is 70INR/USD. So total receivable at spot is 70000 INR.  But trader is afraid that his receivable may get reduced compared to current receivable because exchange rate in future may fell to 60INR/USD thereby receiving only 60000. But there is an option to enter a 1-year forward contract at 70INR/USD. Now Trader A can use eurocurrency market to hedge this currency risk using forward rates as follows:

1) Trader can enter 1year forward rate agreement at 70INR/USD at by paying nominal fees for this service.

2) After 1 year, when the trader receives 1000 USD from the customer, he can exchange it under forward agreement and realise 70000 INR.

3) This strategy eliminates the risk of currency exchange fluctuations for trader A guaranteeing his returns.

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