Assume Rivera’s portfolio was perfectly hedged. It is now time to rebalance the portfolio and roll the currency hedge forward one month. The relevant data for rebalancing are provided in Exhibit 1.
Exhibit 1.
Portfolio and Relevant Market Data
| One Month Ago | Today | |
|---|---|---|
| Portfolio value of assets (USD) | 2,500,000 | 2,650,000 |
| USD/EUR spot rate (bid–offer) | 0.8913/0.8914 | 0.8875/0.8876 |
| One-month forward points (bid–offer) | 25/30 | 20/25 |
Q. Calculate the net cash flow (in euros) to maintain the desired hedge. Show your calculations.
Your Answer:
1
Solution
When hedging one month ago, Delgado would have sold USD2,500,000 one month forward against the euro. Now, with the US dollar-denominated portfolio increasing in value to USD2,650,000, a mismatched FX swap is needed to settle the initial expiring forward contract and establish a new hedge given the higher market value of the US dollar-denominated portfolio.
To calculate the net cash flow (in euros) to maintain the desired hedge, the following steps are necessary:
- Buy USD2,500,000 at the spot rate. Buying US dollars against the euro means selling euros, which is the base currency in the USD/EUR spot rate. Therefore, the bid side of the market must be used to calculate the outflow in euros.USD2,500,000 × 0.8875 = EUR2,218,750.
If the USD/EUR spot rate is 0.8875/0.8876, wouldn’t that mean we would have to pay 1.126760563 Euros for each USD (1 / 0.8875), so 2,500,000 USD would cost us 2,816,901.408 EUR ??