If zero transaction costs. If the 180-day forward rate overestimates the spot rate 180 days from now, then the real cost of hedging payables will be:
The Correct Answer and Explanation is:
If the 180-day forward rate overestimates the spot rate 180 days from now, the real cost of hedging payables will be zero.
Here’s why:
- Hedging with Forward Contracts: In a typical hedging scenario, a company would enter into a forward contract to buy foreign currency at a fixed rate (the forward rate) for future settlement. This guarantees the exchange rate, which can protect against unfavorable fluctuations in the exchange rate.
- Overestimation of Forward Rate: If the forward rate overestimates the spot rate (the exchange rate that will prevail at the time of settlement), this means that the forward contract is priced higher than the rate that will actually occur in the market. Essentially, the company will have locked in a rate that is worse than the market rate.
- Effect on Payables: In the case of payables (where the company owes foreign currency), the company would have agreed to purchase currency at the higher forward rate. When the time comes, if the spot rate is lower than the forward rate (as the forward rate overestimated the actual rate), the company will end up buying the currency at the inflated rate. However, this scenario doesn’t necessarily result in an “additional” cost to the company in the sense of transaction fees or further risk.
- No Transaction Costs: Since zero transaction costs are assumed in this scenario, the only impact is the difference between the forward rate and the spot rate. This could be viewed as a “cost” of hedging, but since the company had certainty about its payable amount (and didn’t face an adverse fluctuation), it would still have effectively avoided the risk of exchange rate volatility.
In summary, although the company might end up paying more than it would have if it had waited for the spot rate, the hedge has removed the uncertainty and protected the company from potential large unfavorable movements in exchange rates. Therefore, the real cost of hedging payables, considering zero transaction costs, is essentially neutral or zero, since the hedge provided certainty, even though it might not have been the optimal rate.
