Exchange Rate Risk Can Be Hedged. The

¶ … exchange rate risk can be hedged. The current cost of the room is £50 per day, which is: 50 * 1.50 = $75.00. For a consumer, the easiest way to hedge this risk would be to purchase pounds today, so that the cost of those pounds is locked in. The transaction is a money-loser because of the time value of money, except that in this situation the nominal amount of pounds is locked in, so the nominal amount of pounds needed will not change. Only the opportunity to make interest on that money changes.

For £50 and one year, this amount is negligible, but for larger transactions the time value of money is significant and important, making this an undesirable option. If the transaction was larger, it could be hedged on the futures market or with interest rate swaps. A forward contract could also be purchased. Futures have a downside in that they have a set date and amount, whereas forward contracts and interest rate swaps can be negotiated between parties.

As a result, futures typically do not provide a perfect hedge whereas most other mechanisms can be designed in such a way as to provide a perfect hedge (Investopedia, 2011). Interest rate swaps involve entering into a deal to exchange a stream of payments for those of a counterparty. The counterparty may have U.S. denominated debt and UK assets; you have the opposite.

In this situation, the risk is related to a singular cash flow rather than a stream of cash flows, so an interest rate swap is not the most appropriate hedging mechanism. The forward contract is the best mechanism in this situation because the two parties can agree to specific terms with respect to the timing of the flows and with respect to the amount of the flows.

The formula for calculating a forward contract is as follows: Ft = S0 * [(1 + R2) / (1 + R1)] If we plug in known the known values, we can determine the forward price of the pound: Ft = 1.50 * [( 1 +.12) / (1+.08)] Ft =.