A company has a foreign-currency-dominated trade payable, due in 60 days. In order to eliminate the foreign exchange risk associated with the payable, the company could
a. Sell foreign currency forward today.
b. Wait 60 days and pay the invoice by purchasing foreign currency in the spot market at that time.
c. Buy foreign currency forward today.
d. Borrow foreign currency today, convert it to domestic currency on the spot market, and invest the funds in a domestic bank deposit until the invoice payment date.
Answer: C
Choice “a” is incorrect. The company needs to arrange to buy the foreign currency in order to make payment to the supplier. This cannot be accomplished by a forward market sale of foreign currency.
Choice “b” is incorrect. Waiting to convert the currency in 60 days’ time does not eliminate the risk of exchange rate movements.
Choice “c” is correct. The company can arrange today for the exchange rate at which it will purchase the foreign currency in 60 days’ time by buying the currency in the forward market. This will eliminate the exchange risk associated with the trade payable.
Choice “d” is incorrect. This strategy would be comparable to a future sale of the foreign currency at a rate known today, which would not provide the currency needed to pay the invoice. The opposite strategy would be an effective money market hedge, however. If the company converted domestic currency to foreign currency in the spot market today and invested in a foreign bank deposit or Treasury bill, it could then use the proceeds from the foreign investment to pay the invoice in 60 days’ time.