Question

1. Suppose that it is July 14, 2020, and ImportCo, a company based in the United States, knows that it will have to pay £10 million on October 14, 2020, for goods it has purchased from a British supplier. ImportCo could hedge its foreign exchange risk by buying pounds (GBP) from the financial institution in the three-month forward market at 2. What is the effect of this hedge?

Answer 1

The Hedging is done by the organisations who are exposed to the foreign Currency Risk i.e. the exporter and importer of good or services who have to either make payments or receive payment at a deferred date. It may happen that they when they receive the payement or make payment in future. the rate is changed and they end up paying more that have to or receive less than they were suppose to,

So, to hedge transaction is done avoid such inconsistency. Once the HEdge is taken, the exchange rate gets fixed and they payement or recevable amount also get fixed. Now they are no more exposed to risk

EFFECT OF HEDGE : - They will pay 10 mn POund * 2 = 20 mn$ only, no matter what the rate is in the market.