Illustration
Problem 8
An Indian subsidiary of a UK multinational has a translation exposure of Rs.10 million.
The rates are as follows:
Spot: Rs.55, 0000/-$
One-year forward: Rs.56, 3200/-$
A 4 percent depreciation of the rupee is expected. How can the exchange risk be hedged?
Solution 8
The anticipated rate after expected depreciation would be: Rs.57.2000/-$
Suppose, no action is taken to hedge the risk. In that case, the company will suffer a
translation loss equal to:
10 million 10 million
$ [ -------------- -------------- ]
55 57.2
= $ 6993To avoid this loss, the company will do well to buy pound sterling forward (or sell rupee
forward) such that the difference is equal to the anticipated loss. Say, it sells Rs.X.
Then,
6993 = X (Forward rate - Anticipated rate)
= 1 1
X [ ----------- - --------------- ]
56.3200 57.2000
or
6993 = X (0.017755680 - 0.017482517)
Or
X = Rs.25, 599,974
This amount of rupees will give the following amount of pound sterling in the forward
market:
25,599,974
-------------- = $ 454,545.45
56, 3200