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Using this simplified example, can you explain the currency movement involved in a over/under hedge please.
A UK company needs to make a US payment of $4.3 million.
Future’s contract sizes = £31,250
Lock-in rate on the future = US 1.4670 per £1
Hence, # of contracts = (4,300,000/1.4670) / £31,250 = 93.80
If I sell 94 contracts this is an over-hedge of US$9,312.50.
Assuming the over-hedge will be settled on the forward market, I know the rate used will be the one least favourable to the UK company, but what is the flow of currency of the over-hedge,that is who holds the over hedge amount, currency exchanges made.
By having 94 contracts they will end up with $9,312.50 more than they actually need for the payment. Therefore they will sell the extra $’s so as to convert back to Pounds. Assuming that forward rates are available they will use the forward rate to convert the $’s back into Pounds.