Question

You manage a company located in the U.S. and the profits you report to your shareholders are in $US. Today your company signed a contract with a Canadian company to import computer parts from Canada with delivery 6 months from today and with the price of the parts in Canadian dollars. You will use these parts to build computers in the U.S. and sell the computers to a Japanese company. You have also signed a contract with the Japanese company today specifying the price per computer in Japanese yen for delivery in one year. There are future contracts in Canadian dollars and in Japanese yen, both priced in U.S. dollars per unit of foreign currency (e.g. $1.3 per Canadian dollar and $.01 per yen). Explain the exchange rate risks your company faces and how you would hedge these risks using futures contracts.

Answer 1

The exchange rate risk faced on the import of parts from Canada is that the US dollar could depreciate relative to the Canadian dollar. In that case, the amount of US dollar cash outflow would be higher because a higher quantity of US dollars is required to purchase each Canadian dollar. This risk can be hedged by buying the futures contract on Canadian dollars. This would lock-in the price at which US dollars can be converted into Canadian dollars, and would hedge the company against exchange rate risk.

The exchange rate risk faced on the sale of computers in Japan is that the US dollar could appreciate relative to the Japanese yen. In that case, the amount of US dollar cash inflow would be lower because a lower quantity of US dollars is received for each Japanese yen. This risk can be hedged by selling the futures contract on Japanese yen. This would lock-in the price at which Japanese yen can be converted into US dollars, and would hedge the company against exchange rate risk.