4 July 2008
A UK company that manufactures electrical equipment has won a contract from a large US company. All the costs will be incurred in the UK. The value of the contract is $2 million to be paid in 6 months' time. The total costs of the contract in the UK are projected to be £1,100,000.
In this situation, the UK company has a sterling-dollar exposure. When the contract was negotiated in September 2003, the prevailing £$ exchange rate was 1.5800 and the forward points to the 6 month settlement date were -0.0300 = 1.5500.
The UK company had 2 choices. It could:
In this situation, the level of profit on the contract depended on where the sterling-dollar exchange rate was in March 2004.
The rate in September 2003 was 1.5800 so the company budgeted to make £165,822 assuming the currency rate would be at a similar level in March 2004.
In fact, by March 2004, the sterling-dollar exchange rate had moved to 1.8500. So the company only received £1,081,081 for their $2,000,000.
This means the company made a loss of nearly £19,000 on the contract and were £184,741 worse off.
In September, the company could have entered into a forward contract where they could have fixed the sterling-dollar exchange rate at 1.5500 for March 2004. There would have been no charge for the forward contract. In this example the company would have been guaranteed to make £190,323.
The rate would have been agreed in September, but the company would still only have had to pay their pounds to World First in March 2004. In this instance, the company knows its profit irrespective of what happens to the sterling-dollar exchange rate between the transaction date and the settlement date.
The exchange rate could have moved the other way but most companies would rather have a fixed, known profit than the risk of a loss.
