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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A US-based importer must pay EUR 2,000,000 in six months. The six-month forward rate is USD 1.10 per EUR. The firm enters a forward contract to buy EUR at this rate. At maturity the spot rate is USD 1.16 per EUR. What is the effective USD cost of the payable, and how does it compare with remaining unhedged?

The forward fixes the cost at EUR 2,000,000 times 1.10, which is USD 2,200,000. Unhedged, the importer would pay 1.16 per euro, or USD 2,320,000, so the hedge saves USD 120,000 because the euro appreciated against the dollar.

  1. AUSD 2,200,000; the hedge saves USD 120,000 compared with being unhedgedCorrect
  2. BUSD 2,320,000; the hedge saves USD 120,000 compared with being unhedged
  3. CUSD 2,200,000; the hedge costs USD 120,000 compared with being unhedged
  4. DUSD 2,320,000; the hedge has no effect on the cost

Explanation

Forward locks in 2,000,000 x 1.10 = USD 2,200,000. Unhedged cost would be 2,000,000 x 1.16 = USD 2,320,000. The hedge saves 2,320,000 - 2,200,000 = USD 120,000. Option 2 wrongly reports the unhedged cost as the hedged cost.

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