FX Forward Hedging Versus Synthetic Hedging with Corporate Debt
Summary
The document compares hedging a future foreign-currency receipt with a forward contract against creating a similar exposure through dollar borrowing, spot conversion, and euro investment. Under covered interest parity, it gives the forward-rate relationship between spot and the two currencies’ interest rates, then questions whether a corporation can replicate that rate when its own borrowing cost includes a credit spread.
The discussion turns on the corporation’s relative borrowing spreads in dollars and euros. One response argues that dollar debt proceeds can offset euro debt, so the spread difference between currencies matters. Another agrees that forwards may be cheaper when corporate borrowing costs exceed the rates used to price forwards. The exchange offers conceptual arguments rather than data or a worked comparison; the relative costs depend on the firm’s funding spreads, collateral terms, and transaction details. The claim that a debt-based implied forward must be lower is therefore not established universally.
Key ideas
- Covered interest parity relates a forward exchange rate to spot and the two currencies’ interest rates.
- A corporate debt hedge may carry borrowing spreads that differ from the rates used to price a forward.
- Comparing synthetic and direct hedges requires considering the firm’s relative funding spreads across currencies.
- The discussion does not establish a universal cost ranking between forwards and debt-based hedges.
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Full text
# FX hedging: forward rate and implied forward rate
# FX hedging: forward rate and implied forward rate
In this paper (box 1 page 24): https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Bulletins/2000/2000mar63-1brookeshargreaveslucaswhite.pdf
It is argued that the forward rate that a corporation receives from entering a forward contract (let's call it $F$) is the same as the implied forward rate from issuing foreign debt (let's call it $\hat{F}$).
Under the assumption that CIP holds, I disagree.
In particular, assume a european corporation that wants to hedge a future exposure (for example coming from future dollar receipts) by buying euros forwards. Then the direct way to do this would be to enter a forward contract and receive euros at the forward rate, $F$; where according to CIP, $F$ is given by:
$F = S \frac{(1+i_{euro})}{(1+i_{dollar})}$
where $S$ is the spot exchange rate (in terms of euros per dollar) and $i_{euro}$ is the interest rate in euro and $i_{dollar}$ is the interest rate in dollar). Because the corporation is presumably entering a transaction with a bank and it is posting a margin collateral, the interest rates could be assumed to be equal to the LIBOR rates.
The paper argues that $F$ can be derived synthetically: the corporation could issue a zero coupon dollar bond, swap the notional in euro at spot $S$ and invest it at the euro rate. The implied forward rate $\hat{F}$ would then be equal to $F$.
My objection is that in this latter case the interest rate at which the corporation is borrowing in dollars must be different from the USD LIBOR rate; in particular I expect that it would reflect a spread due to a risk premium specific to the corporation issuing the dollar bond.
My conclusion is therefore that $\hat{F} < F $ and hence that it would be cheaper for the corporation to hedge the FX exposure by entering into a forward contract.
## Answer by dm63 (score 1)
https://quant.stackexchange.com/a/41341
I don't really agree. The corporation could issue dollar debt, convert the proceeds into Euros and then use this to reduce their amount of Euro debt (either buy some bonds back or issue less). Thus, what is important is the relative spread over Libor that the corporation debt trades at , in dollars versus Euros.
## Answer by Jared M (score 0)
https://quant.stackexchange.com/a/40861
Thanks for pointing it out, it appears that you are right, one of the benefits of using futures or forwards is the interest rates used to calculate their value are indeed lower than a corporation could achieve on their own by borrowing in the capital markets due to the risk premium, as you mentioned. So unless a corporation can borrow at the risk free rate, they should hedge with forwards, which I believe is what the author concludes as well, since this is a simpler transaction.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.