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Foreign Exchange Risk Hedging with Forward Contracts

Richard Clarke

Foreign Exchange Risk Hedging with Forward Contracts: A Simple Explanation

What is FX Hedging with Forward Contracts?

Foreign Exchange (FX) Risk Hedging protects against currency fluctuations impacting cash flows. Forward contracts lock in an exchange rate for a future transaction. In the ACCA AFM exam, you’ll calculate forward rates, assess hedging outcomes, and evaluate financial strategies.

Let’s hedge a US dollar payment for a UK company.

Key Components of Hedging with Forwards

  1. Spot Rate: Current exchange rate (e.g., GBP/USD).
  2. Forward Rate: Adjusted spot rate for future delivery, based on interest rate differentials.
  3. Hedging Outcome: Compare cash flows with and without the hedge.

Formulae

  • Forward Rate = Spot Rate × (1 + Foreign Interest Rate) / (1 + Domestic Interest Rate)
  • Payment in Domestic Currency = Foreign Amount × Forward Rate (hedged)
  • Gain/Loss = Unhedged Payment - Hedged Payment

Numeric Example

A UK company must pay $500,000 to a US supplier in 3 months (March 02, 2025):

  • Spot Rate: GBP/USD 1.30 (1 GBP = 1.30 USD)
  • UK Interest Rate: 4% p.a. (3-month: 1%)
  • US Interest Rate: 2% p.a. (3-month: 0.5%)
  • Forward Contract: Available for 3 months
  • Future Spot Rate (in 3 months): 1.28 (assumed for comparison)

Step 1: Calculate Forward Rate

  • Forward Rate = 1.30 × (1 + 0.005) / (1 + 0.01) = 1.30 × 1.005 / 1.01 = 1.295
  • Forward Rate = 1.295 GBP/USD

Step 2: Calculate Hedged Payment

  • USD Amount = $500,000
  • Hedged Payment = $500,000 ÷ 1.295 = £386,100

Step 3: Compare with Unhedged Payment

  • Unhedged Rate = 1.28 (future spot)
  • Unhedged Payment = $500,000 ÷ 1.28 = £390,625
  • Hedge Gain = £390,625 - £386,100 = £4,525

Step 4: Interpret Results

  • Hedged Cost: £386,100 locked in.
  • Unhedged Cost: £390,625 (if paid at future spot).
  • Gain: £4,525 saved by hedging.

What Does This Mean?

  • Forward Rate (1.295): Locks in a predictable GBP cost.
  • Gain (£4,525): Protects against GBP weakening (USD strengthening).
  • Risk: If GBP strengthens (e.g., to 1.32), unhedged would cost £378,788, a missed saving.

Management might ask: Should we hedge all FX exposure? Are options better than forwards?

Why It Matters for ACCA AFM

FX hedging with forwards tests your ability to:

  • Calculate forward rates using interest rate parity.
  • Evaluate hedging effectiveness under currency volatility.
  • Advise on advanced financial strategies.

Practice with multi-currency deals or options to excel in AFM!