Hedging a Sterling Receivable with a Forward
A UK exporter will receive USD 2,000,000 in 90 days for goods shipped to a US customer. Spot GBP/USD is 1.2650. The 90-day forward points are quoted as a discount of 45 points (i.e. forward GBP/USD = 1.2605). The exporter's treasurer is nervous: she expects the dollar to weaken to 1.30 spot by the payment date, which would reduce her sterling proceeds. She is considering (a) a 90-day forward sale of USD, (b) buying a USD put / GBP call option with a strike of 1.2650 costing 0.8% of notional, or (c) doing nothing and converting at spot. Her board has a policy that hedges must cover at least 70% of known exposures.
1. Calculate the sterling proceeds under the forward hedge and explain what the forward points tell you about relative interest rates.
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Forward proceeds: USD 2,000,000 ÷ 1.2605 = £1,586,672.
Forward points interpretation: GBP/USD forward is lower than spot (1.2605 vs 1.2650), meaning the dollar is at a forward discount / sterling at a forward premium. By covered interest parity, this implies UK interest rates are lower than US rates over the 90-day horizon (or, equivalently, the market prices a higher US rate). The forward points are not a forecast of spot - they purely reflect the interest-rate differential. The treasurer should not read the discount as a prediction that the dollar will fall; that is a separate (and uncertain) view.
2. Compare the forward, the option, and doing nothing in terms of outcome and risk, given the treasurer's view that spot will reach 1.30.
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| Strategy | Proceeds if spot = 1.30 | Proceeds if spot = 1.20 | Certainty |
|---|---|---|---|
| Forward @1.2605 | £1,586,672 | £1,586,672 | Fully fixed |
| Option @1.2650 | Spot 1.30: exercise? No - sell at 1.30 = £1,538,462, minus premium 0.8% (~£12,308) = £1,526,154 | Spot 1.20: exercise at 1.2650 = £1,581,028 − premium £12,308 = £1,568,720 | Floor, upside retained |
| Do nothing | £1,538,462 | £1,666,667 | Fully exposed |
Judgement: The forward locks in £1,586,672 - better than the unhedged outcome if spot does hit 1.30, because the forward rate (1.2605) is more favourable to the exporter than 1.30 (a lower GBP/USD means more sterling per dollar). The treasurer's view that 'a weaker dollar hurts' is correct directionally, but her expected 1.30 is worse than the forward - so the forward already beats her forecast. The option caps downside but its premium erodes proceeds in the likely scenario; it only pays off if spot falls below ~1.2650 minus premium. Doing nothing is the riskiest given board policy.
3. Does the treasurer's preferred course satisfy the board's 70% hedging policy, and what should she recommend?
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Policy test: The board requires ≥70% of known exposure hedged. USD 2,000,000 × 70% = USD 1,400,000 must be hedged.
- Do nothing: 0% hedged - breaches policy outright. Not permissible.
- Full forward: 100% hedged - compliant, and locks £1,586,672, which beats her own 1.30 forecast.
- Option: provides a floor but the unhedged portion is effectively the notional minus the protected amount; a plain option does not 'hedge' in the policy sense unless sized to cover ≥70%.
Recommendation: Hedge at least 70% via forward (e.g. USD 1.4m forward, leaving USD 0.6m exposed to capture upside), or go 100% forward. The forward is the rational choice here because the forward rate already exceeds her expected spot - she is being paid to hedge. The option is only justified if she genuinely values the upside and the premium is within budget; at 0.8% it costs ~£12,300 and only wins in a narrow band. Recommend a layered forward covering ≥70%, with the residual left open or covered by a cheaper collar.