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Chapter Five Foreign Currency Derivatives and Hedging Example 5.8:Cash Flow Hedge of Forecasted Transaction Using a Forward Contract The Case In October 2003,a US company begins construction of a new manufacturing plant with completion expected in the spring of 2005.Once the building has been completed ,the company plans to install manufacturing equipment that it expects to purchase from a German supplier ,The equipment purchase is forecasted for December 2004 with payment due on delivery . In October 2003,the list price of the equipment is €2,000,000 ,equivalent to $1,600,000 at the current spot rate of $0.80 per euro . The US company is worried about the risk that the value of the euro will rise before it purchases the equipment and decides to hedge this risk by entering into a forward contract to buy €2,000,000 on December 31 2004 ,for a forward price of $0.83 each. A forward contract to buy €2,000,000 Record €2,000,000 equipment purchase 2003.10.01 2004.12.31 2003.12.31 Hedging Designation The forward contract is designated as a cash flow hedge of the cash flows related to the forecasted equipment purchase . Explanation: Forecasted or anticipated foreign-currency-denominated transactions can be hedged using derivatives such as forwards or options. Such hedges are classified as cash flow hedges. Expected Hedge Effectiveness The hedge is expected to be highly effective because the settlement dates ,currency type , and currency amounts of the forward contracts and the forecasted transaction are the same. Forecasted equipment Forward contract settlement dates 2004.12.31 2004.12.31 currency type $€ $€ currency amounts €2,000,000 €2,000,000 Subsequent Price Behavior Date Spot Dollar per Euro Rate Forward Dollar per Euro Rate for December 2004 Delivery October 1,2003 $0.800 $0.830 December 31,2003 $0.820 $0.845 December 31,2004 $0.850 $0.850 Date 2003.10.01 2003.12.31 2004.12.31 Forward contract Forward Dollar per Euro Rate $0.830 $0.845 $0.850 Es
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