Example 1

To calculate the outcome of a forward market hedge for Apple Ltd, we

need to determine how much US$ Apple will receive by hedging the A$2
million receivable due in 3 months using the forward market.

Given Data:
Invoice amount: A$2,000,000
Spot rate (A$/US$): 1.2850 (bid) – 1.2880 (ask)
3-month forward rate (A$/US$): 1.3010 (bid) – 1.3055 (ask)

Steps:
1. Identify the appropriate forward rate:
Apple Ltd is receiving A$2 million (selling A$ to buy US$).
In the forward market, Apple will sell A$ at the bid rate (the rate at which
the bank buys A$), which is 1.3010.

2. Calculate the US$ amount received:

The forward rate of 1.3010 means 1 A$ = 1/1.3010 US$.
For A$2,000,000, the US$ amount is: = A$2,000,000/1.3010US$ =
U$1,537,279.02

3. Hedge outcome:
By using the forward market hedge, Apple Ltd locks in a guaranteed
receipt of US$1,537,279.02 in 3 months, regardless of future spot rate
fluctuations.
Therefore, the hedge outcome using a forward market hedge is
US$1,537,279.02.

Example 2
To calculate the outcome of a forward market hedge for Banana Ltd, we
need to determine how many Ugandan Shillings (UGX) Banana Ltd will pay
to settle the £35,000 payable due in 6 months using the forward market.
Given Data:
Invoice amount: £35,000
Spot rate (UGX/£): 3168 (bid) – 3172 (ask)
6-month forward rate (UGX/£): 3105 (bid) – 3112 (ask)
Steps:
1. Identify the appropriate forward rate:
Banana Ltd needs to buy £35,000 (selling UGX to buy £).
In the forward market, Banana Ltd will buy £ at the ask rate (the rate at
which the bank sells £), which is 3112.
2. Calculate the UGX amount required:
The forward rate of 3112 means 1 £ = 3112 UGX.
For £35,000, the UGX amount is:
UGX = £35,000 x 3112UGX = 108,920,000
3. Hedge outcome:
By using the forward market hedge, Banana Ltd locks in a guaranteed
payment of UGX 108,920,000 in 6 months, regardless of future spot rate
fluctuations.
Therefore, the hedge outcome using a forward market hedge is UGX
108,920,000.

Example 3
To calculate the outcome of a forward market hedge for Cassava Ltd, we
need to determine how many Singapore Dollars (S$) Cassava Ltd will pay
to settle the €300,000 payable due in 9 months using the forward market.
Given Data:
 Invoice amount: €300,000
 Spot rate (S$/€): 3.1689 (bid) – 3.1725 (ask)
 9-month forward rate (S$/€): 3.1050 (bid) – 3.1125 (ask)
Steps:
1. Identify the appropriate forward rate:
o Cassava Ltd needs to buy €300,000 (selling S$ to buy €).
o In the forward market, Cassava Ltd will buy € at the ask rate
(the rate at which the bank sells €), which is 3.1125.
2. Calculate the S$ amount required:
o The forward rate of 3.1125 means 1 € = 3.1125 S$.
o For €300,000, the S$ amount is: €300,000 x 3.1125S$
=933,750
3. Hedge outcome:
 o By using the forward market hedge, Cassava Ltd locks in a
guaranteed payment of S$933,750 in 9 months, regardless of
future spot rate fluctuations.
Therefore, the hedge outcome using a forward market hedge is
S$933,750.

Example 4
To calculate the outcome of a money market hedge for Goat Ltd, a UK
firm due to receive US$800,000 in 6 months, we need to determine how
many British Pounds (£) Goat Ltd will receive by hedging this foreign
currency receivable using the money market. The money market hedge
involves borrowing in one currency, converting to another, and investing
to lock in the exchange rate and eliminate currency risk. Below, I’ll explain
each step in detail.
Given Data:
 Receivable amount: US$800,000
 Spot rate (US$/£): 1.8510 (bid) – 1.8550 (ask)
 6-month money market interest rates:
o UK: Loan 8%, Deposit 6%
o USA: Loan 9%, Deposit 7%
 Time period: 6 months (0.5 years)
Money Market Hedge Concept:
Goat Ltd expects to receive US$800,000 in 6 months. To hedge the
currency risk (fluctuations in the US$/£ exchange rate), Goat Ltd can:
1. Borrow US$ today, such that the loan repayment (principal +
interest) in 6 months equals US$800,000.
2. Convert the borrowed US$ to £ at the current spot rate.
3. Invest the £ in the UK money market to earn interest over 6 months.
4. In 6 months, use the US$800,000 receivable to repay the US$ loan,
and collect the matured £ investment.
This locks in the £ amount today, eliminating exchange rate uncertainty
(ies).
Considering a Step-by-Step Calculation.
Step 1: We Determine the US$ amount to borrow today
  Goat Ltd needs to borrow an amount in US$ such that the principal
plus 6 months of interest equals US$800,000.
 The US loan interest rate is 9% per annum, so for 6 months (0.5
years), the interest rate is: Interest rate for 6 months =
(9%×0.5)=4.5% or 0.045
 Let P be the US$ amount to borrow today. The loan repayment in 6
months is: P×(1+0.045)=800,000
 P×1.045=800,000
800,000
 P= = 765,550.24
1.045
This means that Goat Ltd borrows US$765,550.24 today.
Step 2: Convert the borrowed US$ to £ at the spot rate
 Goat Ltd converts the borrowed US$765,550.24 to £ at the current
spot rate.
 Since Goat Ltd is selling US$ to buy £, the bank buys US$ at the bid
rate (1.8510 US$/£), as this is the rate at which the bank purchases
US$.
 The spot rate of 1.8510 means 1 £ = 1.8510 US$, or equivalently,
1
1 US$ = 1.8510 £.

 Convert US$765,550.24 to £:
765,550.24
 £ amount = 1.8510
= 413,587.38

Therefore, Goat Ltd receives £413,587.38 today.

Step 3: Invest the £ in the UK money market
 Goat Ltd invests £413,587.38 in the UK money market at the
deposit rate of 6% per annum.
 For 6 months (0.5 years), the deposit interest rate is:
Interest rate for 6 months = (6%×0.5) = 3% or 0.03
 The investment value after 6 months (using simple interest, as is
common in money market calculations for short periods):
Future value
=413,587.38× (1+0.03) or 413,587.38×1.03 = 426,004.99
Then this means that the investment grows to £426,004.99 in 6
months.
Step 4: Settle the US$ loan in 6 months
 In 6 months, Goat Ltd receives the US$800,000 from the receivable.
 The US$ loan repayment is:
765,550.24×1.045=800,000
 Goat Ltd uses the US$800,000 receivable to repay the loan exactly.
 Result: The loan is fully settled, leaving no currency exposure.
Step 5: Collect the £ investment
 Goat Ltd collects the matured investment of £426,004.99 from the
UK money market.
 This is the hedged amount, guaranteed today, regardless of the spot
exchange rate in 6 months.
Hedge Outcome:
By using the money market hedge, Goat Ltd locks in a guaranteed receipt
of £426,004.99 in 6 months.
Additional Explanation:
 Why borrow in US$? Since the receivable is in US$, borrowing in
US$ ensures that the US$800,000 received in 6 months exactly
offsets the loan repayment, eliminating currency risk.
 Why invest in £? Goat Ltd is a UK firm, so it wants to end up with
£. Investing in the UK money market ensures the funds are in the
desired currency.
 Bid vs. Ask rate: The bid rate (1.8510) is used because Goat Ltd is
selling US$ to the bank, and the bank buys at the lower (bid) rate.
 Simple vs. Compound interest: Money market calculations for
short periods (e.g., 6 months) typically use simple interest, as
reflected in the calculations above. If compound interest were
required, the formula would adjust slightly, but the problem’s
context suggests simple interest.
The hedge outcome using a money market hedge is £426,004.99.

Example 5
To calculate the outcome of a money market hedge for Zebra Ltd, a US
company that needs to pay ¥4,500,000 in 3 months, we need to
determine how many US dollars (US$) Zebra Ltd will need to set aside
today to hedge this foreign currency payable using the money market.
The money market hedge involves borrowing in one currency, converting
to another, and investing to lock in the exchange rate and eliminate
currency risk. Below, I’ll explain each step in detail.
Given Data:
 Payable amount: ¥4,500,000
 Spot rate (¥/US$): 102.10 (bid) – 103.20 (ask)
 3-month money market interest rates:
o Japan (¥): Loan 5%, Deposit 4%
o USA (US$): Loan 9%, Deposit 7%
 Time period: 3 months (0.25 years)
Money Market Hedge Concept:
Zebra Ltd needs to pay ¥4,500,000 in 3 months. To hedge the currency
risk (fluctuations in the ¥/US$ exchange rate), Zebra Ltd can:
1. Borrow US$ today, convert it to ¥ at the current spot rate.
2. Invest the ¥ in the Japanese money market to grow to ¥4,500,000 in
3 months.
3. In 3 months, use the matured ¥ investment to pay the ¥4,500,000
invoice.
4. The US$ borrowed today, plus interest, represents the cost of the
hedge in US$.
This locks in the US$ cost today, eliminating exchange rate uncertainty.
Step-by-Step Calculation:
Step 1: Determine the ¥ amount to invest today
 Zebra Ltd needs to invest an amount in ¥ today such that the
principal plus 3 months of interest equals ¥4,500,000.
 The Japanese deposit interest rate is 4% per annum, so for 3
months (0.25 years), the interest rate is:
Interest rate for 3 months=4%×0.25=1%=0.01\text{Interest rate
for 3 months} = 4\% \times 0.25 = 1\% =
0.01Interest rate for 3 months=4%×0.25=1%=0.01
 Let P be the ¥ amount to invest today. The investment value in 3
months is: P×(1+0.01)=4,500,000P
P×1.01=4,500,000
4,500,000
P= 1.01
= 4,455,445.54
 Therefore, Zebra Ltd needs to invest ¥4,455,445.54 today.
Step 2: Convert US$ to ¥ at the spot rate
 Zebra Ltd needs to obtain ¥4,455,445.54 today by converting US$
at the current spot rate.
 Since Zebra Ltd is buying ¥ (selling US$), the bank sells ¥ at the ask
rate (103.20 ¥/US$), as this is the rate at which the bank sells ¥.
 The spot rate of 103.20 means 1 US$ = 103.20 ¥.
 Calculate the US$ required to obtain ¥4,455,445.54:
4,455,445.54
US$ amount = = 43,171.95
103.20
 Result: Zebra Ltd needs US$43,171.95 today.
Step 3: Borrow US$ and calculate the loan repayment
 Zebra Ltd borrows US$43,171.95 today.
 The US loan interest rate is 9% per annum, so for 3 months (0.25
years), the interest rate is:
Interest rate for 3 months=9%×0.25=2.25%=0.0225
 The loan repayment in 3 months (principal + interest) is:
Loan repayment = 43,171.95 × (1+0.0225) or (43,171.95×1.0225)
= 44,143.33
 Result: Zebra Ltd will repay US$44,143.33 in 3 months.
Step 4: Settle the ¥ payable in 3 months
 The ¥4,455,445.54 invested in the Japanese money market grows
to: 4,455,445.54×1.01=4,500,000
 In 3 months, Zebra Ltd uses the matured ¥4,500,000 to pay the
invoice exactly.
Therefore, then this means that the payable is fully settled.
Step 5: Hedge outcome
 The cost of the hedge is the US$ loan repayment in 3 months, which
is US$44,143.33.
 This is the locked-in cost in US$ that Zebra Ltd will pay, regardless
of the spot exchange rate in 3 months.
Additional Explanation:
  Why borrow in US$? Zebra Ltd is a US company, so borrowing in
US$ aligns with its base currency, and the cost of the hedge is
measured in US$.
 Why invest in ¥? The payable is in ¥, so investing in ¥ ensures that
the matured investment matches the invoice amount.
 Ask rate: The ask rate (103.20) is used because Zebra Ltd is buying
¥ from the bank, and the bank sells at the higher (ask) rate.
 Simple interest: Money market calculations for short periods (e.g.,
3 months) typically use simple interest, as reflected in the
calculations.
The hedge outcome using a money market hedge is US$44,143.33.

Example 6

To hedge the US$1m receipt due in mid-July, Chicken Ltd can use US$/£
futures contracts to lock in an exchange rate and mitigate transaction
risk. Below is a step-by-step guide to hedging using the provided futures
market data.
1. Understand the Exposure
 Chicken Ltd will receive US$1,000,000 in mid-July.
 The company is concerned about the US$ weakening against the £,
which would reduce the £ value of the receipt.
 The goal is to lock in a favourable exchange rate using futures
contracts.
2. Futures Market Data
 June contracts: $1.82/£ (expires end of June)
 September contracts: $1.83/£ (expires end of September)
 December contracts: $1.84/£ (expires end of December)
 Contract size: £25,000 per contract
 Relevant contract: Since the payment is due in mid-July,
the September contract ($1.83/£) is most appropriate, as it
covers the period beyond mid-July and avoids the risk of the June
contract expiring before the payment date.
3. Determine the Hedge Strategy
 Chicken Ltd expects to convert US$1,000,000 into £ in mid-July.
  A weakening US$ (fewer £ per US$) is the risk, so the company
needs to sell US$ futures (equivalent to buying £ futures) to lock
in the exchange rate.
 Selling US$/£ futures means agreeing to deliver US$ at the futures
price ($1.83/£) at the contract’s expiry.
4. Calculate the Number of Contracts
 Amount to hedge: US$1,000,000.
 Contract size: £25,000.
 Exchange rate for September futures: $1.83/£.
 US$ value of one contract: £25,000 × $1.83 = $45,750.
 Number of contracts needed:
Number of contracts = US$1,000,000\US$45,750 = 21.86
 Since futures contracts cannot be divided, Chicken Ltd can either:
 Hedge with 21 contracts (covering US$960,750, leaving
US$39,250 unhedged) or
 Hedge with 22 contracts (covering US$1,006,500, slightly
over-hedging).
 Recommendation: Use 21 contracts to avoid over-hedging, and
manage the small unhedged portion separately (e.g., via the spot
market or forward contract).
5. Execute the Hedge
 Action: Sell 21 US$/£ September futures contracts at $1.83/£.
 Total US$ hedged: 21 × $45,750 = US$960,750.
 £ value locked in: £ = US$960,750\1.83 = £524,999.99
 This locks in approximately £525,000 for US$960,750, regardless of
the spot rate in mid-July.
6. Outcome in Mid-July
 In mid-July, Chicken Ltd receives US$1,000,000.
 Hedged portion (US$960,750):
 Close the futures position by buying back 21 contracts at the
prevailing September futures price (or settle at expiry if held
to September).
  If the spot rate is lower than $1.83/£ (e.g., US$ weakens), the
gain on the futures contract offsets the loss in £ value of the
US$ receipt.
 If the spot rate is higher than $1.83/£ (e.g., US$ strengthens),
the loss on the futures contract is offset by the higher £ value
of the US$ receipt.
 Unhedged portion (US$39,250):
 Convert at the spot rate in mid-July or consider a forward
contract to cover this amount.
7. Comparison with Forward Contract
 The 3-month forward rate is 1.8390 – 1.8480 (bid-ask).
 For selling US$, Chicken Ltd would use the bid rate (1.8390).
 £ value with forward contract: £= US$1,000,000\1.8390 =
£543,772.71
 The forward contract locks in £543,773, slightly higher than the
£525,000 from futures (due to the futures price of $1.83/£ being
less favourable than the forward bid of $1.839/£).
 However, futures offer flexibility (can be closed early) and require
margin payments, while forwards are binding and typically have no
upfront cost.
8. Risks and Considerations
 Basis risk: The futures price may not perfectly track the spot rate
due to changes in interest rate differentials or market conditions.
 Margin requirements: Futures require initial and maintenance
margins, which may involve cash flow considerations.
 Unhedged portion: The US$39,250 remains exposed to spot rate
fluctuations unless separately hedged.
 Contract expiry: The September contract expires after mid-July, so
Chicken Ltd may need to close the position early in mid-July,
introducing slight price risk.
9. Recommendation
 Primary hedge: Sell 21 US$/£ September futures contracts at
$1.83/£ to hedge US$960,750, locking in approximately £525,000.
 Unhedged portion: Consider a forward contract for the remaining
US$39,250 at the 3-month forward rate of 1.8390, yielding:
£ = US$39,250\1.8390 = £21,342.03
  Total £ value: £525,000 + £21,342 ≈ £546,342, close to the full
forward contract value but with the flexibility of futures.
 Monitor the futures position and margin requirements, and close the
futures position in mid-July to align with the payment date.
This approach balances cost, flexibility, and risk, effectively mitigating the
currency risk for Chicken Ltd. If you need further details or a comparison
with other hedging methods (e.g., options), please let me know!