Hedging Foreign Exchange Risk: Forwards, Futures, Options, Money Market Hedge and Swaps Questions

Question 1

State one reason why firms hedge.

Accepted Answer

Firms hedge to protect **profit margins** and make foreign currency cash flows predictable.

Question 2

What is a currency future?

Accepted Answer

**Currency future** is a standardized, exchange-traded contract to buy/sell a currency at a future date with margin and daily settlement.

Question 3

What is a currency option?

Accepted Answer

**Currency option** gives the right (not obligation) to buy or sell foreign currency at a specified rate (strike) on/before a date.

Question 4

What is a currency swap?

Accepted Answer

**Currency swap** is an agreement to exchange principal and interest payments in two different currencies over a period.

Question 5

Define hedging.

Accepted Answer

**Hedging** means taking an action/position to reduce or offset the risk of adverse exchange rate movement on foreign currency exposure.

Question 6

What is a forward contract?

Accepted Answer

**Forward contract** is an OTC agreement to buy/sell a specified foreign currency amount at a fixed rate on a future date.

Question 7

Explain forward contract hedging for an importer and an exporter (any three points).

Accepted Answer

Forward hedging (any three points):

- **Importer (payable)**: buys foreign currency **forward** to lock the future cost and avoid adverse depreciation.
- **Exporter (receivable)**: sells foreign currency **forward** to lock the future receipt and avoid adverse appreciation of home currency.
- Forward removes uncertainty but also removes upside benefit from favorable movement.

Thus, forward contracts provide certainty of exchange rate for future cash flows.

Question 8

Differentiate forwards and futures (any three points) with a table.

Accepted Answer

### **Forwards vs Futures**

- **Forwards** are OTC and customized; **futures** are exchange-traded and standardized.
- forwards have higher counterparty risk; futures have lower counterparty risk due to clearinghouse.
- futures require margin and daily marking-to-market; forwards usually settle at maturity.

Table:

| Basis | **Forward** | **Futures** |
|---|---|---|
| Market | OTC | exchange-traded |
| Terms | flexible | standardized |
| Settlement | maturity | daily MTM + margin |

Hence, futures are more standardized and safer, while forwards offer flexibility.

Question 9

Explain call option and put option with their typical users (any three points) with a table.

Accepted Answer

### **Call vs Put Options (Currency)**

- **Call option**: right to **buy** foreign currency; useful for importers.
- **Put option**: right to **sell** foreign currency; useful for exporters.
- Options give protection but require paying **premium**.

Table:

| Option | Right | Typical user |
|---|---|---|
| **Call** | buy FX | importer (payable) |
| **Put** | sell FX | exporter (receivable) |

Thus, options hedge downside risk while keeping potential upside if exchange rate moves favorably.

Question 10

Explain money market hedge (basic steps) for a payable (3-mark) with a simple flow.

Accepted Answer

### **Money Market Hedge for Payable (Basic Steps)**

- find the present value of foreign currency payable using foreign interest rate.
- convert home currency into foreign currency today at spot.
- invest foreign currency so that it grows to exactly match the payable amount at due date.

Flow:

```text
Compute PV of payable → buy FX now (spot) → invest FX → FX grows → pay liability at maturity
```

Thus, money market hedge locks the effective exchange rate using borrowing/lending rates.

Question 11

Explain options vs forwards: when to choose which (3-mark) with a short table.

Accepted Answer

### **Options vs Forwards (Choice)**

- choose **forward** when you want full certainty and are okay giving up upside.
- choose **option** when you want protection but also want to keep upside benefit.
- option needs **premium**, so it may be costlier.

Table:

| Instrument | Protection | Upside | Cost |
|---|---|---|---|
| **Forward** | yes | no | spread |
| **Option** | yes | yes | premium |

Hence, options are useful when future is uncertain and firm wants flexibility.

Question 12

Explain factors affecting choice of hedging instrument (any three points) with a mini table.

Accepted Answer

### **Choice of Hedging Instrument (Factors)**

Factors (any three):
- **nature of exposure**: receivable vs payable; short-term vs long-term.
- **cost**: forward spread, option premium, futures margin and transaction cost.
- **flexibility needed**: options provide flexibility; forwards lock rate.
- **credit risk**: forward has counterparty risk; futures have clearinghouse support.

Mini table:

| Need | Better choice |
|---|---|
| full certainty | **forward/future** |
| protect + keep upside | **option** |
| long-term cash flows | **swap** |

Thus, firms select instruments based on exposure type, cost, flexibility, and risk considerations.

Question 13

Explain currency swaps: meaning, uses and benefits (exam-style) with a flowchart.

Accepted Answer

### **Currency Swaps — Exam-Style**

**Meaning:** A **currency swap** is an agreement where two parties exchange principal and periodic interest payments in different currencies for a specified period.

#### **Uses**
- hedge long-term foreign currency loans and cash flows.
- obtain funds in a desired currency at a lower effective cost (comparative advantage).
- manage long-term exposure more efficiently than repeated short forwards.

#### **Benefits**
- stable long-term hedging
- can reduce borrowing cost
- improves asset–liability currency matching

Flowchart:

```text
Two parties with opposite currency needs → exchange principal → exchange interest payments over time → re-exchange principal at maturity
```

**Conclusion:** Currency swaps are powerful instruments for long-term FX risk management and international financing strategy.

Question 14

Explain advantages and limitations of hedging (exam-style) with a table.

Accepted Answer

### **Advantages and Limitations of Hedging — Exam-Style**

Hedging reduces uncertainty but involves costs and trade-offs.

Advantages:
- stabilizes **cash flows** and profit margins.
- improves budgeting and pricing decisions.
- reduces financial distress risk.

Limitations:
- costs (option premium, spreads, margin requirements).
- opportunity cost (forward removes upside).
- needs expertise and monitoring.

Table:

| Advantages | Limitations |
|---|---|
| certainty & stability | cost & reduced upside |

**Conclusion:** A good hedge policy balances risk reduction with hedging cost and business objectives.

Question 15

Explain selective hedging vs full hedging and why firms create hedging policies (exam-style) with a mini table.

Accepted Answer

### **Selective Hedging vs Full Hedging — Exam-Style**

- **Full hedging** means hedging all identified exposures to achieve maximum certainty.
- **Selective hedging** means hedging only some exposures based on cost, risk tolerance, or management view.

Why hedging policy is needed:
- sets limits, approved instruments, and responsibilities.
- prevents excessive speculation in the name of hedging.
- ensures consistent risk management and reporting.

Mini table:

| Policy | What it does | Risk |
|---|---|---|
| **Full hedge** | hedge everything | higher cost, no upside |
| **Selective hedge** | hedge chosen exposures | residual risk remains |

**Conclusion:** Hedging policy brings discipline and aligns hedging with business risk appetite and financial goals.

Hedging Foreign Exchange Risk: Forwards, Futures, Options, Money Market Hedge and Swaps

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