Introduction to Corporate Finance

ONLINE CHAPTER

The seller’s profit is the forward rate minus the spot rate on the settlement date. For example, if

the spot rate is US$1.6845/£ in six months, then the buyer’s profit is US$0.0491/£ (US$1.6845/£ –

US$1.6354/£). The seller would have a loss of US$0.0491/£.^3

Currency Forward Rates

Determining the fair forward rate in a currency contract is slightly more complicated than doing so for a

financial asset that pays no income. Unlike the financial asset discussed previously, currencies generate

income in the form of interest earned from investing the currency. However, the principle of how we

determine the fair forward price still applies. For example, rather than buy British pounds three months

forward, we could borrow dollars, convert the dollars to British pounds at the spot rate and invest the

pounds in Britain at the risk-free rate. These transactions guarantee a fixed amount of British pounds in

three months, just as a forward contract does.

In fact, we have already studied a pricing relationship for forward exchange rates. In Chapter 17,

we saw that interest rate parity established conditions under which an investor was indifferent between

investing in a risk-free asset at home or abroad. These conditions are expressed mathematically as follows:

F

S

=

+

+

r

r

1

1

for

dom

This equation says that the ratio of the forward rate to the spot rate (expressed in foreign currency

per unit of domestic currency) must equal the ratio of one plus the foreign risk-free rate divided by one

plus the domestic risk-free rate. If this equation does not hold, then an arbitrage opportunity exists, and

traders can borrow in one country and simultaneously invest in another country to make a quick profit.

Rearranging this equation slightly, we can derive the formula for the fair price of a forward exchange

contract:

Eq. 23.3 =()

+

+











FS 

r

r

1

1

for

dom

example

Suppose that the current spot exchange rate on the Swiss franc (SF) is $0.5800/SF, or SF1.7241/$. The one-

year risk-free rate for borrowing in dollars is 6%, and the rate for borrowing in Swiss francs is 5%. According to

Equation 23.3, the following is the one-year forward exchange rate on the Swiss franc:

F 1.7241

10 .05

10 .06

=() SF1.7078/$

+

+









=

Hedging with Currency Forward Contracts

To see how forward contracts can be used to hedge foreign exchange risk, consider a multinational

company’s treasurer who expects to receive a 10 million Swiss franc (SF) payment in 90 days. Suppose

the spot rate is currently $0.6050/SF. In 90 days, however, the spot rate may be lower. For example, if

3 To understand why the profit or loss from a forward position depends on the spot rate at the settlement date, consider the following. If we pay

US$1.6354/£ on the settlement date and immediately sell the British pounds in the spot market, we will receive US$1.6845/£. The net effect

of this transaction is a cash inflow of US$0.0491/£. On the other hand, if we have the short position, we would be selling British pounds for

US$0.0491/£ less than they are worth, thus experiencing a loss.