Question

Grand Tour Co. buys IT products from a Swedish company.        Grand Tour Co. is based in California, U.S.A. The IT products that it buys are denominated in euros. Grand Tour Co. hedges its exchange rate risk by negotiating six-month contracts. It negotiates a new six-months contract, six months before the next order will arrive. Grand Tour Co. is always covered for the next six-monthly shipments. The CFO of Grand Tour Co. is not concerned about changes in the value of the euro, because he does this hedging. Is Grand Tour Co. fully insulated from exchange rate movements?

Explain your answer.

Answer 1

Since it hedges its exposure every six months, it is insulated from exchange rate movements but only for those 6 months. If after the 6 months, when there will be a new negotiation, if then the exchange rates had already moved against them, then they wouldn't be able to do anything except take the rates offered to them. For e.g. suppose they buy euros at $1.12 per Euro by hedging through forwards. Now, if after 6 months if the rate goes to $1.5 per Euro (hypothetically), then they will be paying for the earlier consignment through this contract but when they will be negotiating the next 6 month contract, they will have to hedge the price at $1.5 per Eur or more. Hence, they were saved only for 6-months and were not completely isolated.