Question

1. Last year, your company sold electronic products to Brazil. You are expecting to receive Real 850,000 in 6 months. The following quotations are provided by a currency dealer:

In $                              per $

            Real                             0.4200                         2.3810

            1 m. forward               0.4210                         2.3753

            3 m. forward               0.4350                         2.2989

            6 m. forward               0.4115                         2.4301

1. Draw the profit/loss graph for your unhedged position. If the spot rate in 6 months is $0.4000/ Real, what would be your profit/loss for your unhedged position (based on the related forward rate quotation)
2. Describe how you can hedge your currency risk. Draw the profit/loss graph for your long or short forward position. If the spot rate in 6 months is $0.4000/Real, what would be your profit/loss for your long or short forward position.
3. Draw your graph for your combined position (unhedged plus long or short forward contract). What is your profit/loss for the combined position?
4. If you are completely confident that the spot rate in 6 months will be 0.4228, do you need to take a short or long position in Real forward contract?

Answer 1

Solution::-

a. The U.S co. is having Real receivable after 6 month, hence it is afraid of Real falling against dollar, therefore the best strategy would be to cover itself in forward market in order to eliminate risk.

The 6 month forward rate is- Dollar 0.4115 for each Real.

Now, if the Co. do not enter into forward market, i.e. remain un hedged, in that case, they would able to sell the real at Dollar 0.40 for each Real.

Hence, based on the related forward rate quotation-

it will be the loss for the co. if it remain un hedged, and the loss amount would be -

= (0.4115 - 0.40)x no. of real receivables

=0.0115 x 850,000

= - $ 9775

This amount can be seen in the graph, as the difference between hedged and unhedged position which is = (-7225) - (-17000)

= - $9775

3