Question

Examples of using forward contracts to hedge foreign exchange risks.

Answer 1

Foreign exchange risk/exposure can be hedged using two alternatives:

• Forward Contracts
• Options

A forward contract is a derivative contract where the buyer enter into a contract with the seller to buy (an obligation) the forex at a predetermined exchange rate. It will zero down the exchange rate today for the transaction to be executed at a future date.

Example:

A company XYZ has a foreign branch in Spain that will be transmitting 15 million Euros in next three months. XYZ will need to convert the euros for the dollars it will be getting from the branch.

In other words, XYZ is long on euros (Invested) and short on dollars (Want to invest). We said "short on dollars" because the company would need to convert the euros it will be receiving in the near future into dollars.

One option would be that XYZ waits next 3 months and see what would happen in the foreign currency markets or enter into a currency forward contract.

To hedge its risk, XYZ can short the forward contract on euro, and go long on the dollar. That is, it will enter into a contract with a bank that whatever the rate of a dollar may be but the XYZ will buy the euro only at a fixed predetermined price.

XYZ goes to American Express and receives a forward contract quotation of .935 in 3 months. This allows XYZ to buy dollars and sell euros. Now XYZ will be able to turn its 15 million euros into 15 million x .935 = 14.025 million dollars in three months.

Three months later if rates fall down and are at .910, Corp. A will be ecstatic because it will have realized a higher exchange rate. However, If the rate has increased to .950, XYZ would still receive the .935 it agreed to receive from American Express, but in this case, XYZ will not have received the benefit of the increased foreign exchange rate.