Forward Contract

A client holds a portfolio of foreign shares and wants to remove the effect of exchange rate movements on its value. Entering a forward contract on the currency would

1. A.fix the rate on the hedged amount, removing both the gain and the loss from currency moves.Correct. A forward is a commitment, so it eliminates movement in both directions rather than one.
2. B.protect against a fall in the foreign currency while leaving any appreciation intact.Wrong. That describes a currency option, which charges a premium the forward does not.
3. C.remove the risk that the foreign shares themselves decline in their local market.Wrong. A currency hedge addresses the exchange rate and leaves equity market risk untouched.
4. D.convert the foreign holding into a domestic security for regulatory purposes.Wrong. A hedge alters the exposure and changes nothing about what the client actually owns.

Why: A currency forward is a binding commitment to exchange a fixed amount at a fixed rate on a future date, so it removes exchange rate movement in both directions on the amount hedged. The client gives up any gain from a strengthening foreign currency in return for protection against a weakening one, and pays no premium for the arrangement. That two-sided character is what distinguishes it from a currency option, which preserves the favourable direction but charges for the privilege. Neither instrument affects the risk that the foreign shares themselves fall in their own currency.

Grain buyer Marguerite Okonjo is comparing two ways to fix the price of a wheat purchase six months from now: an exchange-traded futures contract, and a privately negotiated forward contract with a single milling company. Which statement correctly contrasts the two?

1. A.Both contracts are marked to market daily, so neither leaves Marguerite exposed to counterparty credit risk.Incorrect. Daily mark-to-market and a central clearinghouse are features of futures. A bilateral forward settles only at maturity and leaves full counterparty credit exposure in place.
2. B.The forward contract is the standardized, exchange-traded instrument, while the futures contract is privately customized between the parties.Incorrect, and reversed. Futures are the standardized, exchange-traded instrument; forwards are the customized bilateral agreements.
3. C.Neither instrument requires any margin or collateral, because no money changes hands until delivery.Incorrect. That is true of a plain forward, but a futures position requires an initial margin deposit and daily variation settlement.
4. D.The futures contract is standardized, exchange-traded and marked to market daily through a clearinghouse that becomes the counterparty, while the forward is customized, settles at maturity, and leaves Marguerite exposed to the miller's credit.Correct. Standardization plus central clearing and daily settlement define futures; customization plus bilateral credit exposure defines forwards.

Why: A futures contract is standardized as to quantity, quality, delivery location and delivery month, trades on an organized exchange, and is novated to a clearinghouse that becomes the counterparty to both sides. Positions are marked to market daily, with gains and losses settled in cash against a margin account, which is what keeps credit exposure small. A forward contract is a bilateral, customized agreement: the parties negotiate the terms themselves, nothing changes hands until settlement, and each side bears the other's credit risk for the full term. Forwards offer a precise fit; futures offer liquidity and a creditworthy central counterparty.

Adviser Priya Ramaswamy is choosing between the currency-HEDGED and the UNHEDGED version of the same developed-markets international equity index fund for a U.S. client with a 20-year horizon. Which statement is most accurate?

1. A.The hedged version will always produce the higher return, because eliminating currency risk necessarily improves the outcome.Incorrect. Hedging removes variability, not risk-free return. It costs money to maintain, and it forfeits the gain an unhedged investor earns when the dollar weakens.
2. B.Currency movements do not affect a U.S. investor's return from foreign equities, because the shares are priced in their local markets.Incorrect. The investor ultimately measures results in dollars, so the local return must be translated at the exchange rate, and that translation is part of the return.
3. C.The unhedged version will have lower volatility, because currency and equity returns are perfectly negatively correlated.Incorrect. No such perfect relationship exists. Currency exposure generally raises the short-run volatility of an unhedged foreign equity position for a U.S. investor.
4. D.The unhedged fund's return reflects both local equity returns and currency movements, adding short-term volatility but also diversification against a weakening dollar, while the hedged fund strips currency out at an ongoing cost, leaving pure local equity exposure.Correct. Neither choice is universally superior; the decision turns on horizon, the client's spending currency, and tolerance for currency-driven swings.

Why: A U.S. investor's return on foreign equities has two components: the return of the shares in their local currency, and the change in that currency against the dollar. The unhedged fund delivers both. A weakening dollar adds to the U.S. investor's return, while a strengthening dollar subtracts from it, so currency exposure raises short-term volatility but also provides a genuine diversifying hedge against dollar weakness, which matters to a client who will spend dollars but faces imported costs. The hedged fund uses forward contracts to strip the currency component out, leaving something close to pure local equity return, at the cost of ongoing hedging expense and the loss of the diversification benefit.