Questions: Currency Derivatives and Foreign Exchange Hedging

Question 1

A US importer must pay €1 million in 3 months. The spot rate is 1.10 USD/EUR; the 3-month forward rate is 1.08 USD/EUR. A bank analyst forecasts the euro will fall to 1.07. Should the importer enter the forward contract based on this forecast?

• A. Yes — the forward rate of 1.08 is above the forecast spot of 1.07, so the forward locks in a favorable rate compared to the expected outcome
• B. No — the forward rate is not a forecast; it is an arbitrage-free price set by interest rate differentials. The hedging decision should be based on the importer's risk tolerance, not whether the forward is above or below a spot rate forecast
• C. Yes — forward rates always predict future spot rates better than bank analysts, so the importer should trust the forward
• D. No — importers should only use options, never forwards, because forwards carry counterparty credit risk

Answer: (B)

The covered interest rate parity (CIP) relationship tells us that forward rates are *not* forecasts — they are determined by the no-arbitrage condition F = S × (1 + r_d)/(1 + r_f). The forward rate reflects the interest rate differential between currencies, not the market's consensus expectation of where the spot rate will be. A decision to hedge using a forward should be based on whether the importer wants to eliminate the currency uncertainty in its cash flows — a risk management question — not on a comparison of the forward rate to a spot rate forecast.

Question 2

A US exporter expects to receive between €500,000 and €1,000,000 in 6 months — the exact amount depends on whether a large order is confirmed. Which hedging instrument is most appropriate?

• A. A currency forward for €1 million — locks in the maximum amount at today's forward rate
• B. A put option on €1 million — provides downside protection if the euro depreciates while allowing flexibility if the full amount is not received
• C. A cross-currency swap for 6 months — best suited to trade receivables with uncertain amounts
• D. No hedge is possible when the amount is uncertain

Answer: (B)

When cash flow amounts are uncertain, options are preferred over forwards. A forward obligates the exporter to deliver exactly €1 million at the locked-in rate — if only €500K materializes, the exporter would be short €500K and must buy euros at the spot rate to deliver, potentially at a loss. A put option gives the *right* (not obligation) to sell euros at the strike price; if the full €1 million is received and the euro has appreciated, the exporter simply lets the option expire and benefits from the favorable spot rate. The cost is the option premium. Option A illustrates the classic over-hedging risk of forwards when notional amounts are uncertain.

Question 3

The three-month forward exchange rate between USD and EUR is determined by the no-arbitrage relationship between the spot rate and the interest rate differential between the two currencies, not by market expectations of where the spot rate will be in three months.

• T. True
• F. False

Answer: True

This is the covered interest rate parity (CIP) result: F = S × (1 + r_USD)/(1 + r_EUR). If the forward rate deviated from this, risk-free arbitrage profits would be available by borrowing in one currency, converting at spot, investing in the other, and locking in the return at the forward rate. This arbitrage keeps forward rates anchored to the interest differential. CIP holds reliably in developed-market currency pairs, unlike uncovered interest rate parity (UIP), which predicts actual future spot rates but fails empirically.

Question 4

Buying a currency put option on a foreign-currency receivable provides the same complete elimination of exchange rate risk as entering a currency forward contract.

• T. True
• F. False

Answer: False

A forward eliminates *all* exchange rate risk — both adverse and favorable movements. If the foreign currency appreciates, the exporter loses that upside gain because they're committed to the forward rate. A put option only eliminates *downside* risk: if the currency falls below the strike, the put pays off; if it rises, the holder lets the option expire and benefits from the favorable spot rate. This asymmetric payoff — protection without surrendering upside — is precisely what distinguishes options from forwards, and precisely why options carry an upfront premium. The forward is a risk transfer; the option is a risk elimination on one side only.

Question 5

Explain why a currency forward contract is said to 'transfer' currency risk rather than 'eliminate' it from the world, and what this means for the cost of hedging.

Model answer: A forward contract shifts the currency risk from the hedger to the counterparty (typically a bank or another corporate with offsetting exposure). The uncertainty about the future spot rate still exists in the world — it is simply borne by someone else. The hedger converts an uncertain future foreign-currency cash flow into a certain domestic-currency amount. The 'cost' of this transfer is embedded in the forward-spot differential (determined by the interest rate differential via CIP) and any bid-ask spread. If the hedger's home currency interest rate is lower than the foreign rate, the forward rate will be at a premium (the hedge costs something in expectation); if higher, the forward is at a discount. This is not a fee but a fair price reflecting the opportunity cost of locking in versus remaining exposed.

Students often conflate 'hedging eliminates risk' with 'hedging destroys risk.' The distinction matters because it clarifies that forward pricing is not arbitrary — it is the equilibrium price at which someone else is willing to bear the risk the hedger no longer wants. This also explains why hedging is not free even when there is no explicit fee: the cost is embedded in the forward premium or discount.