Question

You are the treasurer for A Long island Winery. You just received a bill from your French supplier for the wine he sent you for Eurt,000,000. The Euros are due in three months 1. What is your underlying exposure? (Are you long or short Euros before you think about hedging? You owe Euros) 2. Assume the EURUSO 3 month forward exchange rate is $1.10 EUR today. However fomorrow you look at teh rates and the EURUSO 3 month forward rate has risen to S1.12)EUR. When you mark your books to market, what is the gain or loss on the underlying position? For the toolbar, press MLT+F10 (PC) or ALT+FN+F 10 (Mac)

Answer 1

You are short Euros when considering your underlying exposure. If exchange rates move from $1.10 to $1.12 per Euro, this results in a loss of $20,000. Hedging is an option for protecting against such currency fluctuations.

Step-by-step explanation:

As the treasurer for a Long Island Winery who has received a bill in euros, your underlying exposure is that you are short Euros before considering hedging since you owe Euros and don't currently have them. This means if the value of Euros increases, you will have to pay more in your domestic currency (USD) to fulfill the payment.

Regarding the gain or loss on the underlying position with exchange rates changing from $1.10/EUR to $1.12/EUR: Initially, 1 euro cost $1.10, but the cost has risen to $1.12. This indicates a loss on the position because you now need more USD to buy the same amount of Euros you owe, specifically, $0.02 more per Euro. For 1,000,000 Euros, the total loss when marking to market would be $20,000 (1,000,000 Euros * $0.02).

These kinds of financial situations are when firms might consider hedging to protect themselves from unfavorable movements in exchange rates. By signing a contract to hedge, they lock in an exchange rate and protect the value of their transaction from currency fluctuation.