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FRM Part I · FRM Exam Part I · Introduction to Derivatives

A corporate treasurer expects to receive EUR 5 million in three months and wants to lock in the USD value of the receipt using a forward contract. Which position removes the exchange-rate risk, and what is the main residual risk?

The treasurer should sell euros forward. This fixes the USD value of the EUR 5 million receivable regardless of the future exchange rate. Because forwards are bilateral OTC contracts, counterparty default risk remains. Buying euros forward would increase rather than offset the exposure.

  1. ASell EUR forward; counterparty default risk remainsCorrect
  2. BBuy EUR forward; counterparty default risk remains
  3. CSell EUR forward; the exchange-rate risk is fully retained
  4. DBuy EUR forward; the company gains from a falling euro

Explanation

A EUR receivable loses USD value if the euro depreciates, so the treasurer sells EUR forward to fix the rate. Forwards are OTC contracts, so the counterparty may default, which is the residual risk. Buying EUR forward would double the exposure.

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