Currency Forwards question

Hi everyone,

This question confuses me quite a bit:

A company expects to receive EUR50 mio and enters into a cash settlement currency forward to exchange theses euros for USD at $1.23 per euro. If the market is $1.25 per euro at settlement, why does this company lose 1 mio to its counterparty?

I understand the amount, but in my opinion, the company should receive that 1mio instead.

The EURO appreciated at settlement meaining that the company only has to pay 50mio x 1.23 = 61.5mio USD to

get 50 EURO, because it entered the currency forward agreement. That saved the company 1mio USD.

Why is my thought process wrong? The answer says that the company must make a payment of 1mio USD to its counterparty.

Thank you all!

The company is interested in hedging the downside. The other guy says, “OK no problem, I’ll buy your Euro at $1.23 USD”. However the FX went to $1.25, now the guy needs more USD to buy the same Euro from the company. To make the guy whole, the company pays him $1 million USD.

Follow me with this:

  1. The company gets $61.5 M no matter what

  2. Exchange rate goes to $1.25, so the same euros are worth @ $62.5 M

  3. Let’s pretend the company gets the $62.5 M, but the dealer should have only paid $61.5 M - so he needs $1M back from the company to make him whole.

  4. Company pays guy $1M

If the FX went to $1.21, the company would be receiving $1 million instead. The company was protecting their downside and now they are being compensated.

Here we go:

  1. The company agreed to get $61.5 M no matter what

  2. Rate drops to $1.21, so the euros are worth $60.5 M

  3. Let’s say the company gets the $60.5 M, but says, “Dude where’s my other 1M we agreed on?”

  4. Dude abides and sends $1M to the company

Rough Formula:

Payment to long = (Forward - Float) * Amount

These are confusing to me, as well. Here’s how I think of this one:

The two parties engage in an agreement to exchange money at $1.23 (nominal value is EUR 50 million x $1.23 = $61,500,000). No money is exchanged at this time.

When the contract comes due, the rate has depreciated from a $ perspective. The long is “buying” Euros and is now receiving 50 million of them. The long now has to come up with money to pay for the transaction. The value at this point is now (EUR50 million x $1.25 = 62,500,000). The long has to give up an extra $1,000 to pay for something it agree upon at a prior date.

If the long had purchased the Euros at the date of contract inception, it would have been better off because the Euro appreciated. Buy purchasing the contract instead, the long delays the purchase, obtains $ as a less favorable rate to receive EUR50 million .


Dude, you rock! Thanks a bunch!

I think I initially had trouble to understand the first sentence of the question.

The question said: a company expects to receive EUR50 three months from now AND enters into a forward agreement at $1.23.

I thought the company FIRST agreed with the rate of $1.23 and THEN expects to receive EUR50 in three months.

Thinking like this confused me a lot.

So your rough formula for Payment to short would be just the same? It doesn’t matter right?

Thank you! Yours is good too!

If payment to the long is positive, the long receives money. If it is negative, the long pays money. You just have to be careful how to interpret the “long” which is why I use it loosely. It will defintely calculate the payment in absolute terms, but who is paying who is exactly why you should follow the process. Most of the time, no thinking will be needed when the question is structured as you put it.

Glad I can help.