A French company knows that it will have to pay 10 million Swiss francs in three months. The current spot exchange rate is 0.6000 €/SFr. The three-month forward rate is 0.603 €/SFr. The treasurer is worried that the euro will depreciate in the next few weeks.
a. What action can be taken?
b. Three months later, the spot exchange rate turns out to be 0.620 €/SF; was it a wise decision?

Question

Quizplus · Accepted Answer

The Answer is If the treasurer is worried that the euro might depreciate in the next three months, he will certainly be willing to hedge his foreign exchange position right away by trading this risk against the premium included in the forward exchange rate.
a. He will therefore buy 10 million Swiss francs on the three-month forward market at the rate of 0.603 €/SFr. The transaction will be contracted as of the current date but delivery and settlement will only take place three months later. The forward premium is equal to 0.5% for three months, or 2% annualized.
b. Since the spot exchange rate on the day of delivery (0.620 €/SFr) happens to be higher than the contract's forward rate (0.603 €/SFr), this decision can retrospectively be regarded as a wise one. The treasurer paid 10 M* 0.603 =6.03 million euros on the forward market instead of 10 M * 0.620 =6.20 million if he had paid on the spot market. 0.17 million euros were saved through this strategy.

A French Company Knows That It Will Have to Pay