I came accross this example:
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Ms. A owns a bond issued by the Spanish government that matures in three years. It pays a 5% coupon and A reinvests the cash flows in short term securities in Spain. A currently resides in Texas, USA and her global diversification consists entirely of this one bond. The spot rate is USD1.12/EUR but A expects euro to depreciate over the next year.
A uses forward contracts and FX swaps to manage currency risk and plans to rebalance every two months. The two-month forward rate is USD1.10/EUR. A’s total exposure on the bond is EUR2 million.
Assume the bond is worth EUR2.15 million in two months, the two-month forward rate in two months is USD1.08/EUR, and the spot rate in two months is USD1.09/EUR.
Show the steps to execute a dynamic hedge over the next two months.
Solution:
- Today: Enter a forward contract to sell EUR2 million at USD1.10/EUR (USD2,200,000).
- In two months use FX swap: Use spot market to buy EUR2 million to settle the maturing forward contract; enter new forward contract to sell EUR2.15 million at USD1.08/EUR.
Note this is mismatched swap in which the near and far legs of the swap do not match because the portfolio value has changed.
Also note that in spot market, the exchange will be EUR2 million x USD1.09/ EUR = USD2,180,000. This is less than the amount required for the forward contract, so a loss of EUR20,000 will occur.
In a perfect world, A could use the reinvested proceeds from her coupons to cover any FX swap losses. If the spot moved in the opposite direction, A would have had a gain.
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My question is, in step 2, buy EUR 2mln @1.09 to settle the fwd contract, this is lower than the fwd contract price of 1.10 sold in step 1. This should result in a gain not a loss, right? You buy @1.09 and get 1.10 rate.
I got it from Wiley, hope i did not waste my money …