Foreign Exchange Risk Hedging with Forward Contracts
Foreign Exchange Risk Hedging with Forward Contracts: A Simple Explanation
What is FX Hedging with Forward Contracts?
Foreign Exchange (FX) Risk Hedging protects against currency fluctuations impacting cash flows. Forward contracts lock in an exchange rate for a future transaction. In the ACCA AFM exam, you’ll calculate forward rates, assess hedging outcomes, and evaluate financial strategies.
Let’s hedge a US dollar payment for a UK company.
Key Components of Hedging with Forwards
- Spot Rate: Current exchange rate (e.g., GBP/USD).
- Forward Rate: Adjusted spot rate for future delivery, based on interest rate differentials.
- Hedging Outcome: Compare cash flows with and without the hedge.
Formulae
- Forward Rate =
Spot Rate × (1 + Foreign Interest Rate) / (1 + Domestic Interest Rate) - Payment in Domestic Currency =
Foreign Amount × Forward Rate(hedged) - Gain/Loss =
Unhedged Payment - Hedged Payment
Numeric Example
A UK company must pay $500,000 to a US supplier in 3 months (March 02, 2025):
- Spot Rate: GBP/USD 1.30 (1 GBP = 1.30 USD)
- UK Interest Rate: 4% p.a. (3-month: 1%)
- US Interest Rate: 2% p.a. (3-month: 0.5%)
- Forward Contract: Available for 3 months
- Future Spot Rate (in 3 months): 1.28 (assumed for comparison)
Step 1: Calculate Forward Rate
- Forward Rate =
1.30 × (1 + 0.005) / (1 + 0.01) = 1.30 × 1.005 / 1.01 = 1.295 - Forward Rate =
1.295 GBP/USD
Step 2: Calculate Hedged Payment
- USD Amount =
$500,000 - Hedged Payment =
$500,000 ÷ 1.295 = £386,100
Step 3: Compare with Unhedged Payment
- Unhedged Rate =
1.28(future spot) - Unhedged Payment =
$500,000 ÷ 1.28 = £390,625 - Hedge Gain =
£390,625 - £386,100 = £4,525
Step 4: Interpret Results
- Hedged Cost: £386,100 locked in.
- Unhedged Cost: £390,625 (if paid at future spot).
- Gain: £4,525 saved by hedging.
What Does This Mean?
- Forward Rate (1.295): Locks in a predictable GBP cost.
- Gain (£4,525): Protects against GBP weakening (USD strengthening).
- Risk: If GBP strengthens (e.g., to 1.32), unhedged would cost £378,788, a missed saving.
Management might ask: Should we hedge all FX exposure? Are options better than forwards?
Why It Matters for ACCA AFM
FX hedging with forwards tests your ability to:
- Calculate forward rates using interest rate parity.
- Evaluate hedging effectiveness under currency volatility.
- Advise on advanced financial strategies.
Practice with multi-currency deals or options to excel in AFM!