This paper examines methods for hedging exchange rate risk using a practical example involving a GBP/USD currency transaction. It compares available hedging instruments — including direct currency purchase, futures contracts, interest rate swaps, and forward contracts — evaluating their suitability for a single cash flow scenario. The paper then demonstrates how to calculate a forward contract price using the covered interest rate parity formula and identifies an arbitrage opportunity when the market forward rate deviates from the theoretical price. A step-by-step worked example shows how a profit can be extracted through borrowing, investing, and executing a forward contract simultaneously.
Exchange rate risk can be hedged in several ways. In this scenario, the current cost of a hotel room is £50 per day, which converts to: 50 × 1.50 = $75.00. For a consumer, the simplest way to hedge this risk is to purchase pounds today, locking in their cost. This approach is a money-loser in terms of the time value of money, because while the nominal amount of pounds required is fixed, the opportunity to earn interest on those funds is foregone. For £50 over one year this cost is negligible, but for larger transactions the time value of money becomes significant, making direct currency purchase an undesirable option.
If the transaction were larger, it could be hedged on the futures market or through interest rate swaps. A forward contract could also be purchased. Futures have a drawback in that they carry 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 to provide one (Investopedia, 2011).
Interest rate swaps involve entering into an agreement to exchange a stream of payments for those of a counterparty. The counterparty may hold U.S.-denominated debt and UK assets, while you hold the opposite. In this situation, however, the risk relates to a single cash flow rather than a stream of cash flows, making an interest rate swap an unsuitable hedging mechanism.
Futures contracts also present a poor fit here. Because futures have standardized contract sizes and fixed settlement dates, they rarely align precisely with the specific amount and timing of an individual transaction. This structural rigidity means that a futures-based hedge will almost always leave some residual basis risk.
"Selects forward contract for single cash flow"
"Applies covered interest rate parity formula"
"Step-by-step arbitrage profit calculation"
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