438 Planning and Forecasting
A Foreign Currency Hedge
Suppose an American electronics manufacturer has just delivered a large ship-
ment of finished products to a customer in France. The French buyer has
agreed to pay 1 million French francs in exactly 30 days. The manufacturer is
worried that the French franc may be devalued relative to the American dollar
during that interval. If the franc is devalued, the dollar value of the promised
payment will fall and the American manufacturer will suffer losses. The Amer-
ican manufacturer can shed this foreign currency exposure by going short in a
franc for ward contract or a franc future. The contract will specify a quantity
of francs to be exchanged for dollars, at a fixed exchange rate, 30 days in the
future. The contract locks in the terms at which the deferred franc revenue
can be converted to dollars. No matter what happens to the franc-dollar ex-
change rate, the American manufacturer now knows exactly how many dollars
he will receive.
A Short-Term Interest Rate Hedge
Suppose a manufacturer of automotive parts has just delivered a shipment of
finished products to a client. Business has been growing, and the company
has approved plans to expand capacity next year. The manufacturer expects
to receive payment from the customer in 60 days, but will need to use those
funds for the planned capital expenditure 90 days after that. The plan is to
invest the revenue in three-month Treasury bills as soon as the revenue is re-
ceived. Interest rates are currently high. Managers worry that by the time
the receivables are collected from the customer, however, interest rates will
fall, resulting in less interest earned on the invested funds. The company can
hedge against this risk by buying a Treasury bill futures contract, which es-
sentially locks in the price and yield of Treasury bills to be purchased 60
days hence.
Longer-Term Interest Rate Hedge
A manufacturer of speed boats notices that when interest rates rise, sales fall,
and the value of the firm’s stock gets battered. The correlation is easy to un-
derstand. Customers buy boats on credit, and so when rates rise, the boats ef-
fectively become more expensive to buy. In order to insulate the company’s
fortunes from the vicissitudes of interest rates, the company could enter a con-
tract that pays money when rates rise. A short position in a Treasury bond
futures contract would pay off when rates rise and could thus be a desirable
hedge. Each time the futures contract expires, the company can roll over into a
new contract. The size of the position in the futures should be geared to the
f luctuation in sales resulting from changes in interest rates. The Treasury bond
hedge can reduce the volatility in the firm’s net income, and the volatility of
the firm’s equity value.