Question

Suppose that your firm, based in the U.S. with assets in $US, signs a contract to buy a custom-made airplane from a French aircraft manufacturer. The contract price is 100 million euros with delivery of the plane in exactly one year, when you will have to make the payment in full. The interest rate at which you can borrow or lend euros is 6 percent and the interest rate that you can borrow or lend U.S. dollars is 4 percent. The current spot rate is .8333 euros per dollar ($1.2 per euro). There is a one-year futures contract for euros with a price, expressed as dollars per euro, of $1.25 per euro (.8 euros per dollar) and a contract size of 1 million euros. What risk does the firm face? How would you use the futures market to hedge that risk? Is the futures market the best way to hedge this risk in this case? Assume there are no options.

Answer 1

In any cross border transaction where currencies are exchanged, company faces the exchnage rate risk. This risk arises due to unfavorable movement of exchange rate. So, here also company isfacing the exchnage rate risk.

To hedge such risk, future market is proved to be good alternative where the future payment and receivable is locked at the pre-determined exchange rate. Here, also there is a liability of payment of 100 million euros after a year. Ofcourse, in a year the dollar-euro exchange rate would vary. Thus, company may use forward contract to lock-in the exchange rate at which it will fulfill its obligation of payment after a year.

Futures, forward, options, swap etc are the tools that can be used to hedge the risk. Future market privides the best alternative to hedge due to standardization of contract. The risk of default is also nil in future market.