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Foreign exchange risk

5.2 Forward exchange contracts

Used to hedge against transaction risk. Exchange made at pre-agreed forward rate.

Advantages

 flexibility on amount and date

 straightforward

Disadvantages

 contractual commitment

 no opportunity to benefit from favourable rate movements

Question 9

Forward exchange contract

On 1 Sep a US company enters into a contract with a customer for which
€100,000 is due to be received in 6 months. The exchange rate on the date the
contract is entered into is €0.93 = $1.

The company takes on a forward exchange contract with a rate of €0.94 = $1

Calculate the $ received if the exchange rate moves to:

(1) €0.97 = $1

(2) €0.89 = $1

It doesn’t matter which way the exchange rate moves as using the forward
exchange contract locks the rate at €0.94 = $1

$ received = €100,000/0.94 = $106,383

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