HEDGING EXAMPLE USING SEPARATE EXCHANGE RATES

For Example:

The facts are as in previous example, except that the company accounts for the purchase and the forward currency contract separately. The exchange rate at 31 March is NOK 13.00/£.

The NOK 1 million debts that the company incurs on 2 January is valued at £80,000 on that date, but it only costs the company £78,125 to settle it on 31 March. An exchange gain of £1,875 therefore arises.

The company has contracted to buy NOK 1 million for £78,125 on 31 March, but at that date the currency is only worth £76,923 at spot rates. A loss of £1,202 arises on the forward contract.