Question

You expect to receive £1 million in one year. Spot and forward rates are S₀^€/£ = F₁^€/£ = €1.25/£. The sale is invoiced in pounds.

a. Identify your expected pound cash flow on a timeline. Draw a risk profile for this exposure in terms of euros per pound. If the spot rate in one year is S₁^€/£ = €1.50/£, what is your gain or loss on this transaction?

b. How would you hedge this exposure with a forward contract? Use timelines and a risk profile to illustrate the effect of the hedge.

Answer 1

a) Expected Pound Cash flow = £1 million

Risk Profile: Spot Rate forward rate

ē/£ = ē 1/£   ē/£ = ē 1.25/£

Amount receivable ē1 million   ē 1.25 million

If Spot rate after one year   ē/£ = ē 1.5/£

Gain =Spot rate after one year - forward rate of one year

= 1 million * ē 1.5/£ - 1 million * ē 1.25/£

= ē 0.25million

B) Hedging position with Forward contract

case: a) forward rate   ē/£ = ē 1.25/£    case b) forward rate   ē/£ = ē 0.9/£

Case: a) forward rate   ē/£ = ē 1.25/£

i) After One year If Spot rate ē/£ = ē 1/£

Executive contract at forward rate i.e ē 1.25/£

ii) After One year If Spot rate ē/£ = ē 1.40/£

Executive contract at Spot rate i.e ē 1.40/£

and do not exercise forward contract

Case: b) forward rate   ē/£ = ē 0.9/£

i) After One year If Spot rate ē/£ = ē 1.25/£

Executive contract at Spot rate i.e ē 1.25/£ and do not exercise forward contract

ii) After One year If Spot rate ē/£ = ē 0.7/£

Executive contract at forward rate i.e ē 0.9/£