Question

A US firm expects to receive €600,000 in payment from a customer on March 31. What position should the firm take if it wants to hedge the risk associated with this payment a. using a forward contract? b. using futures contracts on the Chicago Mercantile Exchange? c. using an OTC option? (please be specific what position should be used, such as long or short and along those line).

Answer 1

Given that the firm is expected to receive €600,000 in payment from a customer on March 31.

Case (a): Using a Forward Contract:

As the information the firm is long on Euros. So in order to hedge the risk of its position the firm should go short on forwards. It means the firm should sell €600,000 worth of forwards with an expiry of March 31. This helps the firm to get the current exchange rate on the date of expiry irrespective of the exchange rate on March 31.

Case (b): Using a Futures Contract on the Chicago Mercantile Exchange:

Futures are almost same as forwards. And the action that needs to be taken by the firm is also same as forwards. In order to hedge the risk of its position the firm should go short on forwards. It means the firm should sell €600,000 worth of futures with an expiry of March 31. This helps the firm to get the current exchange rate on the date of expiry irrespective of the exchange rate on March 31.

Case (c): Using an OTC option:

In this case it is a little different. Since the firm is long on Euros it should take the opposite position to hedge its risk of exposure. In case of options, the firms should go long on €600,000 worth of put options with an expiry of March 31. But unlike forwards or futures this has a special feature i.e. at the time of expiry the firm will have a choice to exercise the option or not to exercise. If the spot price on March 31 is less than the strike price then the firm may exercise the option. But if the spot price on March 31 is more than the strike price then the firm may not exercise the option.