Question

You manage a company located in the U.S. and the profits you report to your shareholders are in $US. Today your company signed a contract with a Canadian company to import computer parts from Canada with delivery 6 months from today and with the price of the parts in Canadian dollars. You will use these parts to build computers in the U.S. and sell the computers to a Japanese company. You have also signed a contract with the Japanese company today specifying the price per computer in Japanese yen for delivery in one year. There are future contracts in Canadian dollars and in Japanese yen, both priced in U.S. dollars per unit of foreign currency (e.g. $1.3 per Canadian dollar and $.01 per yen). Explain the exchange rate risks your company faces and how you would hedge these risks using futures contracts

Answer 1

Following are the exchange rate risks that the company faces:

1. Appreciation of the Canadian dollar against the USD: If the value of the Canadian dollar goes up against the USD in 6 months, we will have to shell out more US dollars to make the payments to the Canadian company. Rising $ costs will imply lower profits (in $US).

2. Depreciation of the Japanese Yen against the US Dollar: The number of Japanese Yen that we will receive from the Japanese company is fixed as per the contract. If the Japanese Yen falls against the US dollar (i.e. US dollar appreciates against the Yen) in one year's time, the dollar value of our revenue from the sale of parts will actually fall leading to a corresponding fall in the profits in $US

To hedge these risks, the following steps may be taken:

1. To lock in the price of parts as per the current exchange rate between $US and Canadian dollars, we need to go long on 6-month maturity Canadian dollar futures equivalent to cover the total payment as per the contract. This implies that we will receive the Canadian dollars as per the future value of today's exchange rate.

2. Similarly, To lock in the revenue in $US, we need to short sell one-year expiry Japanese Yen futures equivalent to the Japanese Yen that we will receive as per the contract.