Derivatives And Alternative Investments

This article discusses derivatives and alternative investments, focusing on currency forward contracts as a hedging tool to mitigate foreign exchange risk. It explains the mechanism of currency forward rates and provides an example of a company using a forward contract to hedge its exposure to currency fluctuations. The article also highlights the benefits of forward contracts as a cost-effective strategy for covering foreign exchange risk.

Derivatives And Alternative Investments

A derivative contract is a financial contract whose value is derived from an underlying asset.
The buyer agrees to purchase or sell the underlying asset on a predetermined date at a pre-
determined price. There is no need to own such an underlying asset and thereby making it
easier to trade (Du and Schreger 2016).
Currency Forward Contract is a hedging tool used very widely to cover the exposure reacted
to foreign exchange. The purchase or sale of a currency is locked at a rate known for a future
date. There is no upfront payment involved, making this hedging tool popular. Also, it can be
tailored to a particular amount and delivery period, unlike currency futures. They can be
settled on delivery or cash basis subject to prior mutual agreement and specification of the
same beforehand in the contract
The mechanism to determine the currency forward rate is dependent on interest rate
differentials for the currency pair (Engel 2014). For example, assume a current spot rate for
the Euro of US$1 = 1.1500, a one-year interest rate for Euro of 3%, and one-year interest rate
for US dollars of 1.5%.
After one year, based on interest rate parity, US$1 plus interest at 1.5% would be equivalent
to €1.1500 plus interest at 3%.
Gund, a company based in New Jersey, United States is engaged in the production of plush
stuffed animals. It entered into a contract to deliver 100,000 Itty Bitty Boo stuffed unicorns at
the price of €11 apiece. It has an exposure of €1,100,000 which is receivable in 6 months.
The CFO, Chris Jasko, is concerned with the volatility in the USD/EUR exchange rate. The
company is concerned that it will receive fewer USD per EURO after 6 months if EURO
strengthens from its current market rate.
The company should enter into a currency forward contract to sell the €1,100,000 receivable
6 months from now at the 6-month forward rate today. This will ensure that the company has
covered the exposure and has hedged itself. It knows today at what exchange rate with the
Euro receivable will be exchanged.
6 months from now, when the company has fulfilled the order of 100,000 Itty Bitty Boo
stuffed unicorns, if the spot rate of EURO then appreciates, just like the company has
anticipated it will have benefitted from the contract to the extent of the difference between
the forward price and spot price. If the spot rate of EURO, then depreciates the company will
have suffered a notional loss to the difference between the spot price and forward price. This
situation although unfavorable but, when compared to the exposure, appears to be
insignificant due to the volatility prevalent in the forex markets.

The company thereby by entering into a forward contract could save itself from any possible
loss that could have arisen from currency fluctuation. Furthermore, the company does not
incur further costs in the process of entering into a forward contract thereby making it an apt
hedging strategy for covering foreign exchange risk.

Refrence List
Du, W. and Schreger, J., 2016. Local currency sovereign risk. The Journal of Finance, 71(3),
pp.1027-1070
Engel, C., 2014. Exchange rates and interest parity. In Handbook of international economics
(Vol. 4, pp. 453-522). Elsevier.