We now know that the forward exchange rate of the EGP against the dollar is only the result of the interest rate differential in Egypt and America and not the result of analysts’ expectations.
How do we hedge with futures?
The current dollar price = EGP 20
1. Elsewedy Electric knows it takes $100 to supply a ton of copper to manufacture high-pressure cables for a customer.
2. Due to the fluctuations in the exchange rate, the company’s financial management fears the rise in the dollar exchange rate, which hinders the ability of the Contracts Department to price the cable supply contract.
3. The company contacts Banque du Caire to fix the purchase price of $100 after a year according to the futures contract mechanism, and the bank agrees to sell the dollar after a year at EGP 22 on the basis that the interest rate differential between Egypt and America = 10% (the interest rate in Egypt is 10% higher).
4. After a year, there are 3 scenarios:
Scenario 1: Market exchange rate = forward exchange rate = 22
In this case, neither El Sewedy nor the bank loses, and the transaction takes place according to the agreed price without compensation from one party.
Scenario 2: The market exchange rate = 25 pounds, which is higher than the contract price of EGP 22
In this case, the El Sewedy company profited from the hedging because it read the scene well and decided to fix the exchange rate at EGP 22 pounds.
What happens at that time is that the bank pays El Sewedy the difference between the contract price (22) and the current price (25) for each dollar. So, the company earns 3 x $100 = EGP 300.
Therefore, the company can buy $100 from the market at a price of EGP 25 = EGP 2,500, but it is compensated by the bank with EGP 300, so its actual cost = EGP 2,200, which is equivalent to EGP 22 to the dollar.
Scenario 3: The exchange rate did not move and stayed at EGP 20
In this case, El Sewedy loses the difference (EGP 2 for every dollar) and pays Banque du Caire 2 x $100 = EGP 200.
And as in scenario 2, the company buys the dollar from the market at EGP 20, so its cost is EGP 2,000, but due to the compensation to the Bank for EGP 200, the actual cost = EGP 22.
So,
1. The above transaction is called non-deliverable forward because the original amount was not delivered, and one party was satisfied with compensating the other with the exchange rate difference only according to the prices at the end of the contract period (expiration date).
2. In the 3 scenarios, El Sewedy management made sure that whatever the exchange rate in the market after a year, the cost of supplying the dollar will remain fixed at 22 pounds, so it can price the contract while being assured of achieving the target profit margin.
3. Finally, this contract is called a zero-sum game.
