The exposure
A company has agreed to pay a foreign supplier in six months, in the supplier's currency. The amount of foreign currency is fixed by the contract. The number of rupees it will take to buy that currency is not, and will not be known until the day.
That is transaction exposure: a committed cash flow in a currency that is not yours. It is the most tractable of the three exposures a question will name, and the one with clean solutions.
The other two are worth distinguishing, because answers lose marks for treating them alike. Translation exposure arises when foreign assets and liabilities are restated into the home currency for the accounts; it moves reported figures without moving cash, and hedging it can create a cash exposure in order to tidy a balance sheet. Economic exposure is the effect of exchange rates on the business's competitive position — a rival in another currency becoming cheaper — and no forward contract touches it.
The first solution: a forward contract
Agree today with a bank to buy the foreign currency on the day you need it, at a rate fixed now. The exposure is gone: you know the rupee amount from the moment you sign.
A forward rate is not a forecast, and this is the misconception to kill early. It is not the bank's view of where the rate will be. It is today's spot rate adjusted for the interest the two currencies earn in the meantime, and it is fixed by arbitrage rather than opinion:
In words: the forward rate is the spot rate multiplied up by the home interest rate and down by the foreign one, over the period of the contract.
This is covered interest rate parity, and the reason it must hold is that it is enforceable. If the forward rate were anything else, someone could borrow in one currency, convert at spot, deposit in the other, and sell the proceeds forward for a certain profit with no capital at risk. People do look for exactly that, so the relation holds closely in liquid currencies.
It follows that the currency with the higher interest rate trades at a forward discount. If rupee rates exceed dollar rates, a dollar costs more rupees forward than it does spot — which looks like the market predicting a weaker rupee, and is in fact just the interest difference. Reading the forward premium as a forecast is the single most common misunderstanding in this topic.
The second solution: a money-market hedge
Do it yourself, using deposits and loans instead of a forward.
You need a known amount of foreign currency in six months. So buy the foreign currency today — not the whole amount, but the amount which, deposited at the foreign interest rate, grows into exactly what you will owe. Then it sits there until the payment date and the exposure is gone, because you already hold the currency.
Three steps:
2. buy that much foreign currency today at the spot rate
3. deposit it until the payment is due
If the rupees for step 2 have to be borrowed, they are borrowed at the home rate, which is what makes the two hedges comparable: one pays later at the forward rate, the other pays now at spot and finances the gap.
Why the two cost the same
Because the formula for the forward rate is built out of the same two interest rates the money-market hedge uses. The money-market hedge is the arbitrage that forces covered interest parity to hold; the forward contract is a bank doing it for you and charging a spread.
So in a frictionless market the two are identical in cost, and the worked example below shows them agreeing to the paisa. That agreement is not a coincidence to be noted and passed over — it is the content of the parity relation, and it is the best way to convince yourself the relation is not arbitrary.
In practice they differ a little, and a question may ask which to prefer. The forward is simpler, needs no cash today and uses one bank facility. The money-market hedge may be cheaper if the company has idle cash to deposit, or better if forward markets in the currency are thin or unavailable — which for some currencies they are.
The other instruments, briefly
Futures are exchange-traded forwards in standard sizes and dates. The standardisation means the hedge rarely matches the exposure exactly, leaving basis risk, but they are liquid and carry little counterparty risk.
Options give the right to exchange at a set rate without the obligation. That is a genuinely different product: a forward fixes the outcome, while an option fixes the worst outcome and leaves the upside. The difference is paid for in the premium, and an option is the right answer when the exposure itself is uncertain — a tender that may not be won, for instance, where a forward would leave the company hedging a payment it never has to make.
And the cheapest hedge of all: not having the exposure. Invoicing in your own currency, matching foreign receipts against foreign payments, or borrowing in the currency your revenues arrive in all remove the problem rather than offsetting it. A question about hedging policy usually has marks for saying so.
Where marks are lost
Inverting the forward formula. The home rate goes on top when the rate is quoted as home currency per unit of foreign currency. Writing the quotation convention down before substituting is worth the ten seconds.
Using the annual rate for a six-month period. Halve it, or compound it properly, and say which you did.
Depositing the full foreign amount in a money-market hedge. You deposit its present value. Depositing the whole amount over-hedges by the interest.
Reading the forward premium as a forecast. It is an interest differential.
Calling a hedge a failure because the rate moved your way. The hedge bought certainty. Comparing it afterwards with the best available outcome is judging a decision by information it did not have.
Hedging a translation exposure with cash. Say what it would cost and what it would achieve before recommending it.
Questions students ask
If hedging costs nothing, why does any company leave an exposure open?
Several reasons, and a good answer gives more than one. A company with payments and receipts in the same currency is already partly hedged and only the net matters. Hedging has administrative and credit-line costs that are small per transaction and not zero. And some shareholders hold the share for the currency exposure, having diversified deliberately — a point that echoes the dividend and diversification arguments elsewhere in this paper.
Does purchasing power parity give the same answer?
No, and the two are often confused. Covered interest parity is an arbitrage relation about the forward rate today; it holds tightly because violating it is a free lunch. Purchasing power parity is an economic proposition about where spot rates drift over the long run as price levels diverge; it holds loosely at best and over years. Only the first one can be used to price a hedge.
What happens if the underlying payment is cancelled?
The hedge remains, and it is now an exposure rather than a hedge — the company holds a contract to buy currency it no longer needs, and gains or loses as the rate moves. That is the specific risk a forward carries and an option does not, and it is the standard reason to use an option for a contingent exposure.
A worked example
An invented case. Every rate and amount is made up for this example and describes no real market.
Shringar Tools Limited must pay a supplier USD 10,25,000 in six months. The spot rate is ₹83.00 per dollar. Six-month interest rates are 3.5% for rupees and 2.5% for dollars — rates for the six-month period, not annual rates.
The forward rate
= 83.00 × 1.0097561 = ₹83.8097561 per dollar
The dollar is at a forward premium because rupee interest rates are the higher of the two. That is the interest difference and nothing else; it is not a view about the rupee.
Hedge one: the forward contract
Agree today to buy USD 10,25,000 in six months at ₹83.8097561:
Known today, payable then. To compare it with a cost paid today, discount it at the rupee rate:
Hedge two: the money market
Buy the dollars now. Not the whole 10,25,000 — only enough that, with six months' interest at 2.5%, it grows into 10,25,000:
Buying that many dollars today at the spot rate of ₹83.00 costs
Check the deposit grows into the right amount: 10,00,000 × 1.025 = USD 10,25,000. The dollars are in hand six months early, the exposure is gone, and nothing remains to go wrong with the exchange rate.
The two hedges, side by side
money-market hedge, in today's rupees: ₹8,30,00,000
Identical, and exactly so — not to the nearest rupee but to the rupee. Or compare them at the payment date instead, by carrying the money-market cost forward at the rupee rate:
Two completely different transactions — one a single contract with a bank, the other a spot purchase plus a dollar deposit plus six months of rupee financing — and the same rupee figure at both dates. This agreement is covered interest rate parity. It is not a numerical coincidence engineered for the page: the forward rate was calculated from the same two interest rates the money-market hedge uses, so the two cannot differ. Had the bank quoted any other forward rate, the cheaper route would have been a free profit, and that is precisely the pressure that keeps the quoted rate where it is.
Was hedging worth it?
That depends on what the rate does, and the answer is instructive in all three cases. The hedged cost is ₹8,59,05,000 whatever happens.
| Spot rate in six months | Unhedged cost | Hedged cost | Hedging |
|---|---|---|---|
| ₹86.00 | ₹8,81,50,000 | ₹8,59,05,000 | saved ₹22,45,000 |
| ₹83.81 | ₹8,59,05,250 | ₹8,59,05,000 | saved ₹250 |
| ₹81.00 | ₹8,30,25,000 | ₹8,59,05,000 | cost ₹28,80,000 |
In one of the three the hedge cost ₹28.8 lakh. That is not a bad decision revealed by hindsight; it is the price of not having had to find ₹8.8 crore if the rate had gone the other way. The middle row sits almost exactly on the forward rate, and that is the break-even: the hedge wins if the rupee weakens past ₹83.81 and loses if it strengthens.
Read the swing, because it is the reason the exposure was worth hedging at all. Between the best and worst of those three outcomes the unhedged cost moves by 8,81,50,000 − 8,30,25,000 = ₹51,25,000 — half a crore on a single invoice, from a rate moving about three per cent either way. For a company whose margin on the goods is thinner than that, the exchange rate would have decided whether the contract made money. Removing that is what the hedge was for, and it is a better reason than a forecast.
The forward premium, as a last check
The same number to five decimal places, which is the parity relation stated as a percentage rather than as a rate. If a forward quotation ever implies a premium that differs materially from the interest differential, either you have the quotation convention upside down or the two interest rates are not for the same period — and in an exam it is nearly always the second.
Where this fits in CB1
This page explains one idea from CB1 Business Finance. The full CB1 syllabus, with what each part is examined on, sits on the course page, and past-paper style mock exams with full solutions are where you find out whether the idea has stuck under time pressure.
Other CB1 topics explained
- Why financial reporting is regulated, and who it is regulated for
- Share capital and loan capital: why each source costs what it does
- Leasing against buying, and the only comparison that settles it
- Profit is not cash, and why a growing company can run out of money
- Return on capital employed, and the two things that drive it
- Gearing: why borrowing magnifies a shareholder return in both directions
- Modigliani-Miller: why gearing does not create value, and what does
- Dividend irrelevance, and the four reasons dividends still matter
- The cost of capital, and why a project must beat the whole pot
- NPV against IRR, and the three times IRR gives the wrong answer
- Working capital: the days between paying out and being paid
- Valuing a company: discounted cash flow against comparable multiples
- Synergies and the takeover premium: who actually gets the gain
- Company tax in an appraisal, and the relief that reverses the answer
- Interest rate swaps: fixing a floating cost, and where the saving comes from
Stuck on a term rather than the idea? The actuarial glossary defines the notation used above. If something here is wrong or unclear, tell us — these pages get corrected.