Foreign Currency Options
Thus far, we have examined how firms can hedge known foreign currency transaction exposures. Yet, in many circumstances, the firm is uncertain whether the hedged foreign currency cash inflow or outflow will materialize. For example, the previous assumption was that GE learned on January 1 that it had won a contract to supply turbine blades to Lufthansa. But suppose that although GE’s bid on the contract was submitted on January 1, the announcement of the winning bid would not be until April 1. During the three-month period from January 1 to April 1, GE does not know if it will receive a payment of €10 million on December 31. This uncertainty has important consequences for the appropriate hedging strategy.
GE would like to guarantee that the exchange rate does not move against it between the time it bids and the time it gets paid, should it win the contract. The danger of not hedging is that its bid will be selected and the euro will decline in value, possibly wiping out GE’s anticipated profit margin. For example, if the forward rate on April 1 for delivery December 31 falls to €1 = $1.30, the value of the contract will drop from $13.61 million to $13 million, for a loss in value of $610,000.
The apparent solution is for GE to sell the anticipated €10 million receivable forward on January 1. However, if GE does that and loses the bid on the contract, it still has to sell the currency—which it will have to get by buying on the open market, perhaps at a big loss. For example, suppose the forward rate on April 1 for December 31 delivery has risen to $1.402. To eliminate all currency risk on its original forward contract, GE would have to buy €10 million forward at a price of $1.402. The result would be a loss of $410,000 [(1.361 − 1.402) X 10 million] on the forward contract entered into on January 1 at a rate of $1.361.