When expecting to make a future payment in a foreign currency, a firm should take a:
long forward position in the currency to hedge an appreciation of that currency
Explanation for the above choice
“Expecting to make a payment is like being short the currency. The firm would want to take a long forward position. If the currency appreciates and there is no hedge, the firm would pay more. With the hedge, the overall cost in domestic currency is locked in (cost increases will be offset by gains on the forward contract). Of course, the forward contract will result in a loss if the foreign currency actually depreciates, but this will be offset by a decrease in the cost of the underlying transaction”
I am struggling to understand the below statement
‘but this will be offset by a decrease in the cost of the underlying transaction’
Can someone please help me understand what is being explained in the above statement
All they’re saying is that if you gain on the forward, you’ll lose on the original future payment, and if you lose on the forward, you’ll gain on the original future payment.
Suppose that you have a payment of GBP1,000,000 due in 60 days; your home currency is the euro, and the spot exchange rate is GBP/EUR 0.8221. To hedge the exchange rate risk, you enter into a forward contract to receive GBP1,000,000 in 60 days; to keep it simple, assume that the forward rate is also GBP/EUR 0.8221.
If the spot exchange rate in 60 days is, say, GBP/EUR 0.8000, then you lose on the forward (you’ll pay EUR822,100 when the market price is EUR800,000), but you gain on payment you have to make (the market price of GBP1,000,000 has dropped from EUR822,100 to EUR800,000). If the spot exchange rate in 60 days is, say, GBP/EUR 0.8500, then you gain on the forward (you’ll pay EUR822,100 when the market price is EUR850,000), but you lose on payment you have to make (the market price of GBP1,000,000 has risen from EUR822,100 to EUR850,000).
What you make on the swings you lose on the roundabout.
I have a few gaps in my understanding, kindly help (as usual):
Based on your example:
Liability to pay £1,000,000.00 in 60 days
S0=0.8222£/€
Ft=0.8222£/€
Then the anticipated flows will be as follows:
Deliver (sell) £1,000,000.00, and
Receive (buy) £1,216,249*.
*((£1,000,000.00/1)/( 0.8222£/€/1)): since the quote is B/P and not P/B
Is the above correct?
Secondly the following is not clear from your response ‘but you gain on payment you have to make’
Can you kindly elaborate the flows?
I know the response to the question in schweser pro. But I struggle in visualising the life cycle of the transaction and hence I am seeking the help of this forum.