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Hi. I’m stuck on a question concerning hedge effectiveness. Below is my question:
The question says that we have a BHD 12 million receivable after six months. The functional currency of the Company in question is USD. However, based on the facts in the question, the value of BHD is expected to deteriorate against the USD and hence the Company has a risk of receiving fewer Dollars for its sales.
Below is the fact pattern:
The Company has the following exchange rates and interest rates available to it:
A. Spot exchange rate (BHD per USD): 57.31 (Bid); 57.52 (Offer)
B. Six-month forward rate (BHD per USD): 58.41 (Bid); 58.64 (Offer)Six-month interest rates:
BHD: 4% (Borrow); 2% (Deposit)
USD: 2% (Borrow); 0.5% (Deposit)My question: The textbook says that taking out a forward exchange contract on its future BHD receipt is an effective hedge. But based on my understanding, the future rate is lower than the spot rate, how is the hedge effective? Also, what would be the effective hedge against the foreign currency risk?
Thanks.
The point of hiding is to fix the effective exchange rate on the future date. It is not to make a profit or a loss on the exchange rates, and of course we have no idea what the future spot rate will be (although they do expect it to deteriorate which would mean we are likely to end up receiving less).
Please do watch my free lectures on managing foreign exchange risk. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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