For the example of 1 month forward contract being re-rolled for the second month, I couldn’t get what is the downside to the investor if the hedge is not perfect.
At the end of the 1 month, we still do not intend to liquidate our euro investment (which originally worth 1m). Therefore, we roll a forward contract forward. But why is the mismatch a bad thing since the euro investment has changed in value and our new forward position is just reflecting that accordingly? isn’t it still matched?
Also, even if we decided to roll our forward every 3 months, the mismatch is still there, isn’t it?
Also, The mismatch then occurs during the tenure of the first forward contract that worth EUR1 million, right? I know during the tenure of the 1st forward, there will be a mismatch but what is the downside to the investor since the forward contract is going to be forwarded at EUR950k instead, thus, re-establishing the hedge?
Its a bit hard to interpret your questions. Let me answer my own version
Is mismatch bad thing? - I don’t think so. Mismatch has to do with how much your exposure to FC is, hence the hedge.
Does “mismatch” to the FWD transaction (hedge) occur automatically? No. You assess your exposure and design the need to hedge it by rolling it forward.
-------------------------------- back ground
When you roll the hedge forward, it is not necessary to “match” ie., the forward leg=spot leg;
Say you have a EUR1M exposure you want to hedge ie short it to you DC, INR.
The “mismatch” decision has to do with your exposure. ie if your exposure which was EUR1M is now only EUR0.95M, there is no need to match the legs> Your FWD leg is shorter.
If you are rolling the downward (for long) and upward sloping (for short) forward curve, you have a positive roll yield. ie the price 3m later is higher so allows you to reestablish the hedge while gaining simply from the transaction (almost like M2M).
Say your INR (domestic) may have appreciated to what you could buy the same INR 70M for EUR0.9995M, So your FX gain is EUR500, half way through your hedge ie 3m of the 6 months tenure.