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American manufacturer will suffer losses. The American manufacturer can shed this foreign currency
exposure by going short in a euro forward contract or a euro future. The contract will specify a
quantity of euros to be exchanged for dollars at a fixed exchange rate 30 days in the future. The
contract locks in the terms at which the deferred euro revenue can be converted to dollars. No matter
what happens to the euro-dollar exchange rate, the American manufacturer now knows exactly how
many dollars it will receive.
A Short-Term Interest Rate Hedge
Suppose a manufacturer of automotive parts has just delivered a shipment of finished products to a
client. Business has been growing, and the company has approved plans to expand capacity next year.
The manufacturer expects to receive payment from the customer in 60 days, but will need to use those
funds for the planned capital expenditure 90 days after that. The plan is to invest the revenue in threemonth
Treasury bills as soon as the revenue is received. Interest rates are currently high. Managers
worry that by the time the receivables are collected from the customer, however, interest rates will
fall, resulting in less interest earned on the invested funds. The company can hedge against this risk by
buying a Treasury bill futures contract that essentially locks in the price and yield of Treasury bills to
be purchased 60 days hence.
Longer-Term Interest Rate Hedge
A manufacturer of speed boats notices that when interest rates rise, sales fall, and the value of the
firm‟s stock gets battered. The correlation is easy to understand. Customers buy boats on credit, and so
when rates rise, the boats effectively become more expensive to buy. In order to insulate the
company‟s fortunes from the vicissitudes of interest rates, the company could enter a contract that
pays money when rates rise. A short position in a Treasury bond futures contract would pay off when
rates rise and could thus be a desirable hedge. Each time the futures contract expires, the company can
roll over into a new contract. The size of the position in the futures should be geared to the fluctuation
in sales resulting from changes in interest rates. The Treasury bond hedge can reduce the volatility in
the firm‟s net income, as well as the volatility of the firm‟s equity value.
Synthetic Cash
A company‟s pension fund is invested primarily in the stocks of the Standard & Poor‟s 500 index. The
pension fund manager worries that there may be a downturn in the stock market sometime over the
next six months. She considers selling all of the stock and investing the funds in Treasury bills. An
alternative hedge strategy that will save considerable transaction costs would be to short S&P 500
futures contracts. By establishing a short futures position, she locks in the price at which the stocks
will be sold six months hence. The fund is now insulated from any fluctuations in stock prices. Since
the fund is now essentially risk free, it will earn the risk-free interest rate. Selling futures while