In addition to, or instead of, a traditional hedge, General Electric and Lufthansa can agree to share the currency risks associated with their turbine blade contract. Currency risk sharing can be implemented by developing a customized hedge contract embedded in the underlying trade transaction. This hedge contract typically takes the form of a price adjustment clause, whereby a base price is adjusted to reflect certain exchange rate changes. For example, the base price could be set at €10 million, but the parties would share the currency risk beyond a neutral zone. The neutral zone represents the currency range in which risk is not shared.
Suppose the neutral zone is specified as a band of exchange rates: $1.48-1.52/€, with a base rate of $1.50/€. This means that the exchange rate can fall as far as $1.48/€ or rise as high as $1.52/€ without reopening the contract. Within the neutral zone, Lufthansa must pay GE the dollar equivalent of €10 million at the base rate of $1.50, or $15 million. Thus, Lufthansa’s cost within the neutral zone can vary from €9.87 million to €10.14 million (15 million/1.52 to 15 million/1.48). However, if the euro depreciates from $1.50 to, say, $1.40, the actual rate will have moved $0.08 beyond the lower boundary of the neutral zone ($1.48/€). This amount is shared equally. Thus, the exchange rate actually used in settling the transaction is $1.46/€ ($1.50 − 0.08/2). The new price of the turbine blades becomes €10 million X 1.46, or $14.6 million. Lufthansas cost rises to €10.43 million (14,600,000/1.40). In the absence of a risk-sharing agreement, the contract value to GE would have been $14.0 million. Of course, if the euro appreciates beyond the upper bound to, say, $1.60, GE does not get the full benefit of the euro’s rise in value. Instead, the new contract exchange rate becomes $1.54 (1.50 + 0.08/2). GE collects €10 million X 1.54, or $15.4 million, and Lufthansa pays a price of €9.63 million (15,400,000/1.60).
Exhibit 10.8 compares the currency risk protection features of the currency risk-sharing arrangement with that of a traditional forward contract (at a forward rate of $1.479) and a no-hedge alternative. Within the neutral zone, the dollar value of GE’s contract under the risk-sharing agreement stays at $15 million. This situation is equivalent to Lufthansa selling GE a forward contract at the current spot rate of $1.50. Beyond the neutral zone, the contract’s dollar value rises or falls only half as much under the risk-sharing agreement as under the no-hedge alternative. The value of the hedged contract remains the same, regardless of the exchange rate.