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Answer: The hedged outcome could be worse than the un-hedged outcome
A forward contract **locks in an exchange rate** for the future payment. This removes exchange-rate uncertainty, but it does **not** guarantee the best possible outcome. - If the euro rises, the forward hedge is beneficial. - If the euro falls, the importer would have done better **without** hedging. So the hedged outcome **could be worse** than the unhedged outcome. Why the other choices are wrong: - **A**: Hedging reduces risk, but does not ensure a better outcome. - **C**: Forwards and options are not identical; options provide asymmetry, forwards do not. - **D**: There can be good reasons to hedge even in efficient markets, such as reducing uncertainty in cash flows.
Author: Manit Arora
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Q-138.5 A US-based importer knows it will need to pay EUR 10 million (Euros) to a European supplier in exactly three months. To hedge, the importer buys Euros in the three-month currency forward market. Which of the following is TRUE?
A
The hedged outcome must be better than the un-hedged outcome
B
The hedged outcome could be worse than the un-hedged outcome
C
The payoff with currency forwards is identical to the payoff with currency options
D
If markets are efficient, there is no logical reason to use the forward contract
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