Question

A company uses supplies purchased in the U.S. to make a product that it sells in Canada (for C$). It is concerned about long-term depreciation of the Canadian Dollar against the US Dollar. Instead of using just short-term forward contracts. How can the firm offset some of its exposure to its export business? Using the answer to # 2 above, what are possible disadvantages using the above technique?

Answer 1

The reason why the company is worried of depreciation in Canadian dollar (CAD) is that if it depreciates, the same amount of CAD would convert to lower number of US dollar (USD). Now it wants to hedge this risk. If it goes into a forward contract of shorting CAD, then although it doesn't need to pay anything upfront that is at the time of entering into the contract but at the time of expiry of the contract, the conversion rate of CAD to USD is fixed no matter what is the actual exchange rate in the market and forward contract is a obligation therefore the parties to it have to fulfill the contract even if they are making a loss.

Generally to avoid this compulsion another instrument can be used is an option. Put option on CAD will give the buyer the right to sell CAD at a predetermined price for a certain premium to be paid by the buyer at the time of entering into the contract. Here if at the time of expiry, the spot rate is lower than the put option exercise price, then the put option is exercised while if it is higher, then the option is not exercised and CAD is sold in the open market at the spot rate. The writer or the counter party who has received the premium upfront is obligated to do as the buyer of the option wishes while the buyer has no such obligation.

Now coming to the second question, If Option is purchased, the premium is paid upfront but there can be a chance that the option is not exercised and in such cases the premium paid becomes a loss. So there is a trade-off between premium and obligation in case of forward contract and put option