362 Planning and Forecasting
Forward Exchange Contracts
A for ward contract is an agreement to exchange currencies at some future date
at an agreed exchange rate. The exchange rate in a contract for either the pur-
chase or sale of a foreign currency is referred to as the forward rate.For w a r d
contracts are among the most popular of the foreign-currency derivatives, fol-
lowed by privately negotiated (over-the-counter) currency options.^14 These pri-
vately negotiated contracts can be tailored to meet the user ’s needs in term of
both the amount of currency and maturity of the contract. Exchange-traded
currency derivatives, such as options and futures, come in standard amounts of
currency and a limited number of relatively short maturities.
Forward-Contract Hedging Example An example may help to illustrate the
application of a for ward contract to hedging currency exposure. Near the end
of 2000, the for ward contract rate for the British pound sterling (£), with a
term of one month, was about $1.45. The $1.45 is the direct exchange rate be-
cause it expresses the price of the foreign currency in terms of dollars. The
comparable indirect rate is found by simply taking the reciprocal of $1.45:
1/$1.45 equals 0.69. The dollar is worth 0.69 pounds.
If a U.S. firm had an account payable of 100,000 pounds due in 30 days, a
hedge of this liability exposure could be effected by entering into a for ward
contract to buy £100,000 for delivery in 30 days. Buying the currency through
the for ward contract is necessary because the firm needs the pound in 30 days
to satisfy its account payable. If the dollar were to decline to $1.48 against the
pound over this 30-day period, then the dollar value of the account payable
would increase, creating a foreign-currency transaction loss. That is, it would
take more dollars to purchase the £100,000. However, offsetting this loss would
be a gain from an increase in the value of the for ward contract. The right to buy
£100,000 at the fixed for ward rate of $1.45 increases in value as the value of
the pound increases to $1.48. The effects of this foreign-currency exposure and
associated for ward-contract hedge are summarized in Exhibit 12.4. For the
EXHIBIT 12.4 Hedge of foreign-currency liability exposure with a
forward contract.
Item hedged: account payable of £100,000
Value of the account payable at payment date, £100,000 ×$1.48= $148,000
Value of the account payable when initially recorded, £100,000 ×$1.45= 145,000
Foreign currency transaction loss $ 3,000
Hedging instrument: forward contract to buy £100,000 @ $1.45, 30 days
Value of the for ward contract at maturity, £100,000 ×($1.48−$1.45)= $ 3,000
Value of the for ward contract at inception, £100,000 ×($1.45−$1.45)= 0
Gain on for ward contract $ 3,000