Hedging Exchange Rate | Currency risk using Forward exchange contracts
A forward exchange contract is a binding agreement to sell (deliver) or buy an agreed amount of currency at a specified time in the future at an agreed exchange rate (the forward rate).
In practice there are various ways in which the relationship between a current exchange rate (spot rate) and the forward rate can be described.
However, for each spot and forward there is always a pair of rates given. For example:
|Spot||€/£||1.2025 ± 0.03 ie 1.2028
|Three-month forward rate||€/£||1.2020 ± 0.06 ie 1.2026
£100 would be changed now for either €120.28 or €120.22. Guess which rate the bank will give you! You will always be given the exchange rate which leaves you less well off, so here you will be given a rate of 1.2022, if changing £ to euros now, or 1.2014 if using a forward contract. Once you have decided which direction one rate is for, the other rate is used when converting the other way. So:
|€ to £||£ to €|
|Three month forward rate||€/£||1.2026||1.2014|
So, let’s assume you are a manufacturer in Italy, exporting to the UK. You have agreed that the sale is worth £500,000, to be received in three months, and wish to hedge (reduce your risk) against currency movements.
In three months you will want to change £ to € and you can enter a binding agreement with a bank that in three months you will deliver £500,000 and that the bank will give you £500,000 x 1.2014 = €600,700 in return. That rate, and the number of euros you will receive, is now guaranteed irrespective of what the spot rate is at the time. Of course if the £ had strengthened against the € (say to €/£ = 1.5) you might feel aggrieved as you could have then received €750,000, but income maximisation is not the point of hedging: its point is to provide certainty and you can now put €600,700 into your cash flow forecast with confidence.