Question

You enter into an agreement to sell your products to a local Mexican company. To better the deal, you allow the Mexican company to pay you in Pesos and to pay after they have sold the merchandise they bought from you. You sell 100,000 Pesos in product. At the time of the sale, the Pesos was trading at $2.00 (Sale Date). After some consideration, you decide it would be best to sell Pesos in the forward market. You do so by selling the Pesos in 6 months for $1.80 (Forward Contract). The Mexican company sells the goods and pays you six months later. The exchange rate for the Pesos is $1.70 (Payment Date).

How did you try to protect yourself in the case above? How did this transaction accomplish this goal? In what other ways could you manage the above risk?   

Answer 1

In the case above, I had entered into a forward exchange contract which allows the execution of an agreed amount of foreign currency receivable, or payable at a predetermined rate on a future date. Thus a forward contract was entered at $1.80 since it was anticipated that the rate will further depreciate and fall. Thus, by entering into a forward contract, this risk was covered.

This transaction accomplished the goal since on the payment date the actual rate fell down to $1.70. Thus, the difference between the rate at which the forward contract was entered into and the actual rate led to a net savings of ($1.80-$1.70) being $0.10 which would otherwise not be possible if the forward contract was not entered into.

However, to hedge against such foreign exchange risks, other ways can be used like:

• Money Market cover
• Futures