Question 23.2: Assume that in January 2009, banks were offering one-year cu...
Assume that in January 2009, banks were offering one-year currency forward contracts with a forward exchange rate of $1.29/€. Suppose that at that time, Manzini placed the order with Campagnolo with a price of 500,000 euros and simultaneously entered into a forward contract to purchase 500,000 euros at
a forward exchange rate of $1.29/€ in January 2010. What payment would Manzini be required to make in January 2010?
PLAN
If Manzini enters into a forward contract locking in an exchange rate of $1.29/euro, then it doesn’t matter what the actual exchange rate is in January 2010—Manzini will be able to buy 500,000 euros for $1.29/euro.
EXECUTE
Even though the exchange rate rose to $1.45/€ in January 2010, making the euro more expensive, Manzini would obtain the 500,000 euros using the forward contract at the forward exchange rate of $1.29/€. Thus, Manzini must pay:
500,000 euros \times $1.29/euro = $645,000 in January 2010
Manzini would pay this amount to the bank in exchange for 500,000 euros, which are then paid to Campagnolo.
EVALUATE
This forward contract would have been a good deal for Manzini. Without the hedge, it would have had to exchange dollars for euros at the prevailing rate of $1.45/€, raising its cost to $725,000. However, the exchange rate could have moved the other way. If the exchange rate had fallen to $1.15/€, the forward contract would still commit Manzini to pay $1.29/€. In other words, the forward contract locks in the exchange rate and eliminates the risk—whether the movement of the exchange rate is favorable or unfavorable.