Question

Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced €10 million payable insix months. Currently, the six-month forward exchange rate is $1.10/€ and the foreign exchange advisor for Cray Researchpredicts that the spot rate is likely to be $1.05/€ in six months.(a) What is the expected gain/ loss from the forward hedging?(b) If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? Why or whynot?(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange ratequoted today. Would you recommend hedging in this case? Why or why not?

Answer 1

Answer:

a) The expected loss from the forward hedging = $432,900

b) No I wouldn’t recommend hedging the euro receivable based on the fact that the future spot rate is better off than the forward exchange rate.  

c) No I wouldn’t because in any case whether you hedge or not there will be no difference.

Explanation:

Solution.

Forward Exchange Rate = $1.10/€, therefore the equivalent of €10 million receivable from Germany in 6-month time = €10 million / Forward exchange rate ($1.10) = $9,090,909

However, the 6 months spot rate is $1.05/€, therefore if we simply wait till 6 months we will receive €10 million / Forward spot rate ($1.05) = $9,523,809.

a) The expected loss from the forward hedging = $9,523,809 - $9,523,809 = $432,900

b) No I wouldn’t recommend hedging the euro receivable based on the fact that the future spot rate is better off than the forward exchange rate.  

c) No I wouldn’t because in any case whether you hedge or not there will be no difference. You’ll just end up paying hedging fees which will impact on profits adversely.  

However it is always advisable to hedge foreign exchange risks because predictions could differ from reality and adverse movements in exchange rates could carry significant financial consequences which may not be comparable to the hedging costs.