In a forward market hedge, a company that is long a foreign currency will sell the foreign currency forward, whereas a company that is short a foreign currency will buy the currency forward. In this way, the company can fix the dollar value of future foreign currency cash flow. For example, by selling forward the proceeds from its sale of turbine blades, GE can effectively transform the currency denomination of its €10 million receivable from euros to dollars, thereby eliminating all currency risk on the sale. For example, suppose the current spot price for the euro is $1.500/€, and the one-year forward rate is $1.479/€. Then, a forward sale of €10 million for delivery in one year will yield GE $14.79 million on December 31. Exhibit 10.6 shows the cash-flow consequences of combining the forward sale with the euro receivable, given three possible exchange rate scenarios.
Regardless of what happens to the future spot rate, Exhibit 10.6 demonstrates that GE still gets to collect $14.79 million on its turbine sale. Any exchange gain or loss on the forward contract will be offset by a corresponding exchange loss or gain on the receivable. The effects of this transaction also can be seen with the following simple T-account describing GE’s position as of December 31:
Exhibit 10.6 Possible Outcomes of Forward Market Hedge as of December 31
December 31: GE T-Account (Millions)
Forward contract payment
Forward contract receipt
Without hedging, GE will have a €10 million asset whose value will fluctuate with the exchange rate. The forward contract creates an equal euro liability, offset by an asset worth $14.79 million dollars. The euro asset and liability cancel each other out, and GE is left with a $14.79 million asset.
This example illustrates another point as well: Hedging with forward contracts eliminates the downside risk at the expense of forgoing the upside potential.