A U.S. importer makes a purchase from a German firm in the amount of 21,000 euro

Question

A U.S. importer makes a purchase from a German firm in the amount of 21,000 euros. At the current spot rate of 0.75 euros per dollar, how much is this purchase in U.S. dollars? Next, consider that this U.S firm will not have to pay the German firm for 90 days and that the U.S. firm is concerned that the dollar might weaken over this 90-day period. Suppose the U.S. firm completes a forward hedge at the 90-day forward rate of 0.725 euros per dollar. If in 90 days the dollar weakens so that the spot rate is 0.70 euros per dollar, how much of a loss (in dollars) will the U.S. firm have avoided by hedging its exchange rate exposure?

Explanation / Answer

Let us proceed step by step.

(a) At the time of purchase,

USD price of the purchase = EUR 21,000 / 0.75 EUR per USD = 28,000 USD

(b) The forward contract implies that, after 90 days, the US firm will buy euros at 0.725 EUR per USD, so that it can pay the German firm in Euros, after 90 days.

To buy 21,000 Euros at an exchange rate of 0.725, the US firm has to pay EUR 21,000 /0.725 EUR per USD = 28,966 USD

(c) After 90 days, the market rate of Euro becomes 0.70 EUR per USD.

So, if the firm purchased 21,000 Euros from free market (without the forward contract), it needed to pay EURO 21,000 / 0.70 EUR per USD = 30,000 USD

(d) So, firm has avoided a loss of USD (30,000 - 28,966) = USD 1,034 by hedging the exposure.

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