Hedging with Foreign Exchange Derivatives Carson Company expects that it will re

Question

Hedging with Foreign Exchange Derivatives

Carson Company expects that it will receive a large order from the government of Spain. If the order occurs, Carson will be paid about 3 million euros. Since all of its expenses are in dollars, Carson would like to hedge this position. Carson has contacted a bank with brokerage subsidiaries that can help it hedge with foreign exchange derivatives.

a. How could Carson use currency futures to hedge its position?

b. What is the risk of hedging with currency futures?

c. How could Carson use currency options to hedge
its position?

d. Explain the advantage and disadvantage to Carson
of using currency options instead of currency futures.

Explanation / Answer

a. Use of Currency futures: Currency future is a contract eo exchange one currency for another at a future date at an exchange rate that is fixed as on the date of purchase.

For Example if 1 $ (US Dollar) =62 INR (Indian Rupee) today and a future contract is purchased for settling the currency at 1$ = 64 INR 1 year from today, then after an year the buyer of the contract can purchase the $ at 64 INR irrespective of its presnet price. If the spot after a year is at 1$=66 INR, the the buyer is at profit and can purchase the $ at 64 INR.

b. Risk with currency future is that it is a contract has the two counterparties are bound and obliged to perform the contract irrespective of the spot rate on the expiry date. So there is an unlimited risk for both the buyer and the seller of the currency contract.

c. In case they use currency options, the buyer of an option has the right to decide whether to excerise the option or not based on the spot price on the expiry date. Hence the risk for one party is limited.If the compnay purchase the call option of $1 = 64 INR with an expiry of an year,then the buyer can decide whether to exercise it or not.

For example, if the spot price after an year for a dollar is 66 INR, the buyer will exercise it and if it lower lower than $64, he will not exercise the option. Hence the loss for th buyer of the call option is limited to the extent of the premium he pays to purchase the option.

d.The advnatage of using currency option is that the dowside risk can be limited and with currency futures, the loss or the downside risk is unlimited sine both parties have to oblige the contract.

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