2009 Q.9

Just wanted to get some intuitive understanding:

Maple Leaf International is a Canadian corporation with business in Europe. Maple

Leaf’s business transactions generate exchange rate risk between the Canadian dollar (CAD) and

the euro (EUR).

Maple Leaf is long a forward contract on EUR 50 million at 1.63 CAD/EUR, expiring in six months.

The current spot exchange rate is 1.64 CAD/EUR. The current rate in Canada is 3% and in Euro is 4.5%.

Compute the forward value to Maple Leaf.

I calculated the new forward price as 1.64* (1.03)^.5/1.045^.5 = 1.628187

To mean this says that according to the original forward contract, Maple Leaf will sell its Euros for $1.63 and according to the new forward contract, will be able to sell Euros for only $1.628187. Therefore, it has a gain of (1.63-1.628187)*50 million = 90,650/1.03^.5 = 89,314. This answer makes sense to me because the Canadian company will sell its Euros and get 1.63 for each euro (selling euros forward to hedge F/X risk). However, the solution says that the value to the Canadian company is actually -ve: -89,314. I have searched the threads but have not found any intuitive understandin. The Canadian company locked in a higher rate (1.63) for each euro. Had it waited it will get only 1.628187 for each euro. Isn’t the Canadian company better off by entering into the original forward contract?

solution says that the value to the Canadian company is actually -ve: -89,314 Yes this means that the other party bears the credit risk.

Basically use this method Value to the long = So / (1+Rf)^t -F/ (1+Rd)^t

if this value is +ve long bears the credit risk, othersie short bears the risk