MAF603

CURRENCY RISK

LEARNING OBJECTIVES
1. Explain the meaning and causes of translation risk, transaction risk and economic
risk.
2. Describe how the balance of payments can cause exchange rate fluctuations.
3. Explain the impact of purchasing power parity on exchange rate fluctuations.
4. Use purchasing power parity theory to forecast exchange rates.
5. Explain the impact of interest rate parity on exchange rate fluctuations.
6. Use interest rate parity theory to forecast exchange rates.
7. Explain the principle of four-way equivalence and the impact on exchange rate
fluctuations.
8. Assess the impact on an organization to exposure in translation, transaction and
economic risks and how these can be managed.
9. Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
 The use of the forward exchange market and the creation of a money market
hedge
1. Exchange Rates

1.1 Direct and indirect currency quotes

1.1.1 A direct quote is the amount of domestic currency which is equal to one foreign
currency unit.
1.1.2 An indirect quote is the amount of foreign currency which is equal to one domestic
currency unit.
1.1.3 In the UK, indirect quotes are invariably used but, in most countries, direct quotes are
more common.

1.2 Bid and offer prices

1.2.1 The bid price is the rate at which the bank is willing to buy the currency.
1.2.2 The offer (or ask) price is the rate at which the bank is willing to sell the currency.

Example 1 – Bid and offer prices

Calculate how many dollars an exporter would receive or how many dollars an importer
would pay, ignoring the bank’s commission, in each of the following situations, if they were
to exchange currency at the spot rate.

(a) A US exporter receives a payment from a Danish customer of 150,000 kroner

(b) A US importer buys goods from a Japanese supplier and pays 1 million yen

Spot rates are as follows.

Bank sells (offer) Bank buys (bid)

Danish Kr/$ 9.4340 9.5380
Japanese Yen/$ 203.650 205.781

Solution:

(a) The bank is being asked to buy the Danish kroners and will give the exporter:
150,000
 $15,726.57
9.5380
(b) The bank is being asked to sell the yen to the importer and will charge for the currency
1,000,000
 $4,910.39
203.650
1.3 Spread

1.3.1 The difference between bid price and the offer price, covering dealers’ costs and profit,
is called the spread. The spread can be quoted in different ways.

£/$0.6500 +/– 0.0005 or £/$0.6495 – 0.6505

Example 2 – Spread
ABC Inc, a US based company, is engaged in both import and export activities. During a
particular month, ABC sells goods to Posh plc, a UK company, and receives £5 million. In
the same month, ABC imports goods from a UK supplier, which cost £5 million.

If the exchange rates were £/$0.5075 +/– 0.0003, calculate the dollar values of the sterling
receipt and payment.

(a) As an exporter, ABC will pay a high rate to buy dollars (sell pounds) – that is, they
will be quoted a rate of 0.5075 + 0.0003 = 0.5078. ABC Inc will therefore receive

£5 million/0.5078 = $9,846,396

(b) As an importer, ABC will receive a low rate to sell dollars (buy pounds) – that is, a
rate of 0.5075 – 0.0003 = 0.5072. ABC Inc will therefore pay £5 million/0.5072 =
$9,858,044

2. Types of Foreign Currency Risk

2.1 Currency risk

2.1.1 Currency risk occurs in three forms: transaction exposure (short-term), economic
exposure (effect on present value of longer term cash flows) and translation
exposure (book gains or losses).

2.2 Transaction risk

2.2.1 Transaction Risk

Transaction risk is the risk of an exchange rate changing between the transaction
date and the subsequent settlement date, i.e. it is the gain or loss arising on
conversion.
It arises primarily on import and exports.
2.2.2 Example 3
A UK company, buy goods from Redland which cost 100,000 Reds (the local
currency). The goods are re-sold in the UK for £32,000. At the time of the import
purchases the exchange rate for Reds against sterling is 3.5650 – 3.5800.

Required:
(a) What is the expected profit on the re-sale?
(b) What would the actual profit be if the spot rate at the time when the currency
is received has moved to:
(i) 3.0800 – 3.0950
(ii) 4.0650 – 4.0800?
Ignore bank commission charges.

Solution:
(a) The UK company must buy Reds to pay the supplier, and so the bank is
selling Reds. The expected profit is as follows.
£
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 3.5650) 28,050.49
Expected profit 3,949.51

(b)(i) If the actual spot rate for the UK company to buy and the bank to sell the
Reds is 3.0800, the result is as follows.
£
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 3.0800) 32,467.53
Loss (467.53)

(b)(ii) If the actual spot rate for the UK company to buy and the bank to sell the
Reds is 4.0650, the result is as follows.
£
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 4.0650) 24,600.25
Profit 7,399.75

This variation in the final sterling cost of the goods (and thus the profit) illustrated
the concept of transaction risk.
2.2.3 A firm decides to hedge – take action to minimize – the risk, if it is:
(a) a material amount
(b) over a material time period
(c) thought likely exchange rates will change significantly.

2.2.4 As transaction risk has a potential impact on the cash flows of a company, most
companies choose to hedge against such exposure. Measuring and monitoring
transaction risk is normally an important component of treasury management.

2.3 Economic risk

2.3.1 Economic Risk

Economic risk is the variation in the value of the business (i.e. the present value
of future cash flows) due to unexpected changes in exchange rates. It is the
long-term version of transaction risk.

2.3.2 For example, a UK company might use raw materials which are priced in US dollars,
but export its products mainly within the EU. A depreciation of sterling against the
dollar or an appreciation of sterling against other EU currencies will both erode the
competitiveness of the company. Economic exposure can be difficult to avoid,
although diversification of the supplier and customer base across different
countries will reduce this kind of exposure to risk.

2.4 Translation risk

2.4.1 Translation Risk

This is the risk that the organization will make exchange losses when the
accounting results of its foreign branches or subsidiaries are translated into
the home currency. Translation losses can result, for example, from restating the
book value of a foreign subsidiary’s assets at the exchange rate on the statement of
financial position date.
3. The Causes of Exchange Rate Fluctuations

3.1 Balance of payments

3.1.1 Changes in exchange rates result from changes in the demand for and supply of the
currency. These changes may occur for a variety of reasons, e.g. due to changes in
international trade or capital flows between economies.
3.1.2 Balance of payments – Since currencies are required to finance international trade,
changes in trade may lead to changes in exchange rates. In principle:
(a) demand for imports in the US represents a demand for foreign currency or a
supply of dollars.
(b) overseas demand for US exports represents a demand for dollars or a supply of
the currency.
3.1.3 Thus a country with a current account deficit where imports exceed exports may
expect to see its exchange rate depreciate, since the supply of the currency (imports)
will exceed the demand for the currency (exports).

3.2 Capital movements

3.2.1 There are also capital movements between economies. These transactions are
effectively switching bank deposits from one currency to another. These flows are
now more important than the volume of trade in goods and services.
3.2.2 Thus supply/demand for a currency may reflect events on the capital account. Several
factors may lead to inflows or outflows of capital:
(a) changes in interest rates: rising (falling) interest rates will attract a capital
inflow (outflow) and a demand (supply) for the currency
(b) inflation: asset holders will not wish to hold financial assets in a currency
whose value is falling because of inflation.

3.3 Purchasing power parity theory (PPP)

3.3.1 Purchasing Power Parity

PPP claims that the rate of exchange between two currencies depends on the
relative inflation rates within the respective countries. In equilibrium, identical
goods must cost the same, regardless of the currency in which they are sold.

PPP predicts that the country with the higher inflation will be subject to a
depreciation of its currency.
 Formally, if you need to estimate the expected future spot rates, PPP can be
expressed in the following formula:
S1 1  hc

S 0 1  hb
Where: S0 = Current spot rate
S1 = Expected future rate
hb = Inflation rate in country for which the spot is quoted (base country)
hc = Inflation rate in the other country (country currency).

3.3.2 Example 4
An item costs $3,000 in the US.

Assume that sterling and the US dollar are at PPP equilibrium, at the current spot
rate of $1.50/£, i.e. the sterling price x current spot rate of $1.50 = dollar price.

The spot rate is the rate at which currency can be exchanged today.

The US market The UK market

Cost of item now $3,000 $1.50 £2,000
Estimated inflation 5% 3%
Cost in one year $3,150 £2,060

The law of one price states that the item must always cost the same. Therefore in
one year:
$3,150 must equal £2,060, and also the expected future spot rate can be calculated:
$3,150 / £2,060 = $1.5291/£

By formula:
S1 1  5%

1.50 1  3%
S1  $1.5291
3.3.3 Case Study – Big Mac Index
An amusing example of PPP is the Economist’s Big Mac Index. Under PPP
movements in countries’ exchange rates should in the long-term mean that the
prices of an identical basket of goods or services are equalized. The McDonalds
Big Mac represents this basket.

The index compares local Big Mac prices with the price of Big Macs in America.
This comparison is used to forecast what exchange rates should be, and this is then
compared with the actual exchange rates to decide which currencies are over and
under-valued.

3.3.4 PPP can be used as our best predictor of future spot rates; however it suffers from the
following major limitations:
(a) the future inflation rates are only estimates
(b) the market is dominated by speculative transactions (98%) as opposed to trade
transactions; therefore PPP breaks down
(c) government intervention – governments may manage exchange rates, thus
defying the forces pressing towards PPP.
3.3.5 However, it is likely that the PPP may be more useful for predicting long-run
changes in exchange rates since these are more likely to be determined by the
underlying competitiveness of economies, as measured by the model.

3.4 Interest rate parity theory (IRP)

3.4.1 Interest Rate Parity (IRP)

The IRP claims that the difference between the spot and the forward exchange rates
is equal to the differential between interest rates available in the two currencies.

IRP predicts that the country with the higher interest rate will see the forward
rate for its currency subject to a depreciation.

If you need to calculate the forward rate in one year’s time:

F0 1  ic

S 0 1  ib
Where: F0 = Forward rate
S0 = Current spot rate
ib = interest rate for base currency
ic = interest rate for counter currency
3.4.2 Example 5
UK investor invests in a one-year US bond with a 9.2% interest rate as this
compares well with similar risk UK bonds offering 7.12%. The current spot rate is
$1.5/£.

When the investment matures and the dollars are converted into sterling, IRP states
that the investor will have achieved the same return as if the money had been
invested in UK government bonds.

In 1 year, £1.0712 million must equate to $1.638 million so what you gain in extra
interest, you lose on an adverse movement in exchange rates.

The forward rates moves to bring about interest rate parity amongst different
currencies:
$1.638 ÷ £1.0712 = $1.5291

By formula:

F0 1  9.2%

1.5 1  7.12%
F0  $1.5291

3.4.3 The IRPT generally holds true in practice. There are no bargain interest rates to be had
on loans/deposits in one currency rather than another. However, it suffers from the
following limitations:
(a) government controls on capital markets
(b) controls on currency trading
 (c) intervention in foreign exchange markets.
3.4.4 The interest rate parity model shows that it may be possible to predict exchange rate
movements by referring to differences in nominal exchange rates. If the forward
exchange rate for sterling against the dollar was no higher than the spot rate but US
nominal interest rates were higher, the following would happen:
(a) UK investors would shift funds to the US in order to secure the higher interest
rates, since they would suffer no exchange losses when they converted $ back
to £.
(b) the flow of capital from the UK to the US would raise UK interest rates and
force up the spot rate for the US$.

3.5 Expectations theory

3.5.1 The expectations theory claims that the current forward rate is an unbiased
predictor of the spot rate at that point in the future.
3.5.2 If a trader takes the view that the forward rate is lower than the expected future spot
price, there is an incentive to buy forward. The buying pressure on the forward rates
raises the price, until the forward price equals the market consensus view on the
expected future spot price.

3.6 The International Fisher Effect

3.6.1 The International Fisher Effect claims that the interest rate differentials between
two countries provide an unbiased predictor of future changes in the spot rate of
exchange.
3.6.2 The International Fisher Effect assumes that all countries will have the same real
interest rate, although nominal or money rates may differ due to expected inflation
rates. Thus the interest rate differential between two countries should be equal to
the expected inflation differential. Therefore, countries with higher expected
inflation rates will have higher nominal interest rates, and vice versa.
3.6.3 The currency of countries with relatively high interest rates is expected to
depreciate against currencies with lower interest rates, because the higher interest
rates are considered necessary to compensate for the anticipated currency
depreciation.
3.6.4 Given free movement of capital internationally, this idea suggests that the real rate of
return in different countries will equalize as a result of adjustments to spot exchange
rates. The International Fisher Effect can be expressed as:

1  i a 1  ha

1  ib 1  hb
Where: ia = the nominal interest rate in country a
ib = the nominal interest rate in country b
ha = the inflation rate in country a
hb = the inflation rate in country b

3.7 Four-way equivalence

3.7.1 The four theories can be pulled together to show the overall relationship between spot
rates, interest rates, inflation rates and the forward and expected future spot rates. As
shown above, these relationships can be used to forecast exchange rates.
4. Internal Hedging Techniques

4.1 Invoice in home currency

4.1.1 One easy way is to insist that all foreign customers pay in your home currency and
that your company pays for all imports in your home currency.
4.1.2 However the exchange rate risk has not gone away, it has just been passed onto the
customer. Your customer may not be too happy with your strategy and simply look for
an alternative supplier.
4.1.3 Achievable if you are in a monopoly position, however in a competitive environment
this is an unrealistic approach.

4.2 Do nothing
4.2.1 In the long run, the company would “win some, lose some”. This method
(a) works for small occasional transactions
(b) saves in transaction costs
(c) is dangerous.

4.3 Leading and lagging

4.3.1 Leading involves accelerating payments to avoid potential additional costs due to
currency rate movements.
4.3.2 Lagging is the practice of delaying payments if currency rate movements are expected
to make the later payment cheaper.

Example 6 – Leading and lagging

Williams Inc – a company based in the US – imports goods from the UK. The company is
due to make a payment of £500,000 to a UK supplier in one month’s time. The current
exchange rate is as follows:
£0.6450 = $1

(a) If the dollar is expected to appreciate against sterling by 2% in the next month and by
a further 1% in the second month what would be Williams Inc’s strategy in terms of
leading and lagging and by how much would the company benefit from this strategy?
(b) If the dollar was to depreciate against sterling by 2% in the next month and by a
further 1% in the second month, how would Williams Inc’s strategy probably change
and what would the resulting benefit be?
Solution:

(a) Dollar appreciating against sterling

If the dollar appreciates against sterling, this means that the dollar value of payments will be
smaller in two months’ time than if payment was made when due. Williams Inc will
therefore adopt a ‘lagging’ approach to its payment – that is it will delay payment by an
extra month to reduce the dollar cost.

Payment to UK supplier

One month’s time Two month’s time

Exchange rate £0.6450 × 1.02 = £0.6579 £0.6579 × 1.01 = £0.6645
$ value of payment £500,000/0.6579 = $759,994 £500,000/0.6645 = $752,445

By delaying the payment by an extra month Williams Inc will save $7,549.

(b) Dollar depreciating against sterling

The opposite strategy should now be adopted. As the dollar depreciates, there is an incentive
for Williams Inc to pay as soon as possible. The dollar value of sterling payments will
increase as the dollar depreciates therefore to save money the company will want to pay on
time.
Payment to UK supplier

One month’s time Two month’s time

Exchange rate £0.6450 × 0.98 = £0.6321 £0.6321 × 0.99 = £0.6258
$ value of payment £500,000/0.6321 = $791,014 £500,000/0.6258 = $798,977

By paying on time Williams Inc will save $7,963.

Companies should be aware of the potential finance costs associated with paying early.
This is the interest cost on the money used to make the payment, but early settlement
discounts may be available. Before deciding on a strategy of making advanced payments,
the company should compare how much they save in terms of currency with the finance
costs of making early payment.
By delaying payments there may be a loss of goodwill from the supplier which may result
in tighter credit terms in the future. Whilst savings may have been made by paying late, the
company must compare these savings with potential future costs resulting from, for
example, withdrawal of favourable credit terms or early settlement discounts.

4.4 Matching

4.4.1 When a company has receipts and payments in the same foreign currency due at the
same time, it can simply match them against each other. It is then only necessary to
deal on the foreign exchange (forex) markets for the unmatched portion of the total
transactions.
Suppose that ABC Co has the following receipts and payments in three months time:

4.5 Netting

2.5.1 The terms netting and matching are often used interchangeably but strictly speaking
they are different:
(a) Netting refers to netting off group receipts and payments.
(b) Matching extends this concept to include third parties such as external
suppliers and customers.
4.5.2 In the case of bilateral netting, only two companies are involved. The lower balance
is netted off against the higher balance and the difference is the amount remaining to
be paid.
4.5.3 Multilateral netting is a more complex procedure in which the debts of more than
two group companies are netted off against each other. The arrangement might be
coordinated by the company’s central treasury or alternatively by the company’s
bankers.
4.5.4 Multilateral netting involves minimizing the number of transactions taking place
through each country’s banks. This limits the fees that these banks receive for
undertaking the transactions and therefore some governments do not allow
multilateral netting in order to maximize the fees their local banks receive.
4.5.5 On the other hand, some other governments allow multilateral netting in the belief
that this will be make companies more willing to operate from those countries and
any banking fees lost will be more than compensated by the extra business these
companies and their subsidiaries bring into the country.
4.5.6 Tabular method (transaction matrix)
Step 1: Set up a table with the name of each company down the side and across the
top.
Step 2: Input all the amounts owing from one company to another into the table and
convert them into a common (base) currency (at spot rate).
Step 3: By adding across and down the table, identify the total amount payable and
the total amount receivable by each company.
Step 4: Compute the net payable or receivable, and convert back into the original
currency.

Example 7 – Multilateral netting

P is the parent company of a group that contains 3 subsidiaries: Q (based in Europe), R
(based in the USA) and S based in Canada. The following cash flows are due in 2 months’
time between P and its subsidiaries:

Owed by Owed to Amount

P S CAN$ 3 million
P R US$ 5 million
Q R US$ 4 million
Q S CAN$ 7 million
R S CAN$ 2 million
R P US$ 6 million
S Q EUR 12 million
S P CAN$ 5 million

Mid rate exchange rates in two months’ time are expected to be:

£1 = US$1.60
£1 = EUR 1.20
£1 = CAN$ 1.50

Required:
Calculate, using a tabular format (transaction matrix), the impact of undertaking
multilateral netting by P and its three subsidiary companies for the cash flows due in
two months.

Solution:
Note that all foreign currency amounts have been translated into £ using the given mid rates.

In £ million Paid by
Paid to P Q R S Total
P 3.750 3.333 7.083
Q 10.000 10.000
R 3.125 2.500 5.625
S 2.000 4.667 1.333 8.000
Total payment (5.125) (7.167) (5.083) (13.333)
Total receipt 7.083 10.000 5.625 8.000
Net receipt/(payment) 1.958 2.833 0.542 (5.333)

So overall, S needs to pay amounts equivalent to the above figures to each of P, Q and R in
two months’ time.

Question 1
X, Y and Z are three companies within the same UK based international group. W is a
company outside of the group. The following liabilities have been identified for the
forthcoming year:
Owed by Owed to Amount (millions)
X Y €39
Y X £10
Y W $20
Z X ￥200
Z Y €15
W X $15
W Z ￥100

Mid-market spot rates are:

£1 = $2.00
£1 = €1.50
£1 = ￥250

Required:
Establish the net indebtedness that would require external hedging.

5. Managing Transaction Risk – Forward Contracts

5.1 Characteristics of forward contracts

5.1.1 A forward contract allows a business to buy or sell a currency on a fixed future date at
a predetermined rate, i.e. the forward rate of exchange.
5.1.2 A forward exchange contract is:
(a) An immediately firm and binding contract, e.g. between a bank and its
customer.
(b) For the purchase or sale of a specified quantity of a stated foreign currency.
(c) At a rate of exchange fixed at the time the contract is made.
(d) For performance (delivery of the currency and payment for it) at a future time
which is agreed when making the contract (this future time will be either a
specified date, or any time between two specified dates).

5.1.3 The rule for adding or subtracting discounts and premiums

Forward rate cheaper => Quoted at discount => added to the spot rate

Forward rate more expensive => Quoted at premium => subtracted from the spot rate

5.1.4 Quotation of forward rates

Banks will quote a spread based on the forward bid and offer prices. For example the
$/€ 3-month forward rate might be quoted as:

$1.3495 – $1.3525 / € or 1.3510 ± 0.0015 / €

Example 8 – Forward contract

An Australian firm has just bought some machinery from a US supplier for US$250,000
with payment due in 3 months time. Exchange rates are quoted as follows:

Spot (US$/A$) 0.7785 – 0.7891

3 months forward 0.21 – 0.18 cents premium

Required:

Calculate the amount payable if a forward contract is used.

Solution:

Step 1: Get the appropriate spot rate from the spread (remember the bank always win):
0.7785
Step 2: Adjust to get the forward rate (remember to add discounts and deduct premium)
0.7785 – 0.0021 = 0.7764
Step 3: Payment in three months’ time = 250,000 ÷ 0.7764 = A$322,000

5.1.5 Advantages and disadvantages:

Advantages Disadvantages
 Flexibility with regard to the amount to  Contractual commitment that must be
be covered. completed on the due date.
 Relatively straightforward both to  No opportunity to benefit from
comprehend and to organize. favourable movements in exchange
rates.
 Only major currencies, such as $, £,
Yen or Euro, have the forward markets

6. Money Market Hedge

6.1 Principle of money market hedge

6.1.1 Money Market Hedge

Money market hedge involves borrowing in one currency, converting the money
borrowed into another currency and putting the money on deposit until the
time the transaction is completed, hoping to take advantage of favourable interest
rate movements.

6.2 Setting up a money market hedge for a foreign currency payment

6.2.1 Suppose a British company needs to pay a Swiss creditor in Swiss francs in three
months time. It does not have enough cash to pay now, but will have sufficient in
three months time. Instead of negotiating a forward contract, the company could:

Step 1: Borrow the appropriate amount in pounds now

Step 2: Convert the pounds to francs immediately
Step 3: Put the francs on deposit in a Swiss franc bank account
Step 4: When time comes to pay the company:
(a) pay the creditor out of the franc bank account
(b) repays the pound loan account

Example 9 – Money market hedge for payment

A UK company owes a Danish creditor Kr3,500,000 in three months time. The spot
exchange rate is Kr/£ 7.5509 – 7.5548. The company can borrow in Sterling for 3 months at
8.60% per annum and can deposit kroners for 3 months at 10% per annum. What is the cost
in pounds with a money market hedge and what effective forward rate would this represent?
Solution:
The interest rates for 3 months are 2.15% to borrow in pounds and 2.5% to deposit in
kroners. The company needs to deposit enough kroners now so that the total including
interest will be Kr3,500,000 in three months’ time. This means depositing:

Kr3,500,000/(1 + 0.025) = Kr3,414,634.

These kroners will cost £452,215 (spot rate 7.5509). The company must borrow this amount
and, with three months interest of 2.15%, will have to repay:

£452,215 × (1 + 0.0215) = £461,938.

Thus, in three months, the Danish creditor will be paid out of the Danish bank account and
the company will effectively be paying £461,938 to satisfy this debt. The effective forward
rate which the company has manufactured is 3,500,000/461,938 = 7.5768. This effective
forward rate shows the kroner at a discount to the pound because the kroner interest
rate is higher than the sterling rate.
6.3 Setting up a money market hedge for a foreign currency receipt

6.3.1 A similar technique can be used to cover a foreign currency receipt from a debtor. To
manufacture a forward exchange rate, follow the steps below.
Step 1: Borrow the appropriate amount in foreign currency today
Step 2: Convert it immediately to home currency
Step 3: Place it on deposit in the home currency
Step 4: When the debtor’s cash is received:
(a) Repay the foreign currency loan
(b) Take the cash from the home currency deposit account

Example 10 – Money market hedge for receipts

A UK company is owed SFr 2,500,000 in three months time by a Swiss company. The spot
exchange rate is SFr/£ 2.2498 – 2.2510. The company can deposit in Sterling for 3 months
at 8.00% per annum and can borrow Swiss Francs for 3 months at 7.00% per annum. What
is the receipt in pounds with a money market hedge and what effective forward rate would
this represent?

Solution:

The interest rates for 3 months are 2.00% to deposit in pounds and 1.75% to borrow in
Swiss francs. The company needs to borrow SFr2,500,000/1.0175 = SFr2,457,003 today.
These Swiss francs will be converted to £ at 2,457,003/2.2510 = £1,091,516. The company
must deposit this amount and, with three months interest of 2.00%, will have earned

£1,091,516 × (1 + 0.02) = £1,113,346

Thus, in three months, the loan will be paid out of the proceeds from the debtor and the
company will receive £1,113,346. The effective forward rate which the company has
manufactured is 2,500,000/1,113,346 = 2.2455. This effective forward rate shows the
Swiss franc at a premium to the pound because the Swiss franc interest rate is lower
than the sterling rate.

6.4 Choosing the hedging method

6.4.1 The choice between forward and money markets is generally made on the basis of
which method is cheaper, with other factors being of limited significance.
6.4.2 When a company expects to receive or pay a sum of foreign currency in the next few
months, it can choose between using the forward exchange market and the money
market to hedge against the foreign exchange risk. Other methods may also be
possible, such as making lead payments. The cheapest method available is the one
that ought to be chosen.