# FX hedging: forward rate and implied forward rate

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.

• Not sure if this is still active, but I think if we're speaking down to the minutiae of including the risk on issuing the debt for achieving F, the \hat{F} would include some credit adjustment for the credit risk of the corporation and make that value slightly higher than some theoretically risk free counterparty. – Tanay Trivedi Dec 17 '19 at 4:33

• Thank You. Are you referring to this strategy in the context of FX hedging? In the sense, that the firm by buying back her own debt can in fact save an amount of interest which will then go in the determination of an implied forward rate: $\hat{F} = S \frac{1+i_e^c}{1+i_d^c}$, where $i_e^c$ is the corporate bond rate in euros and $i_e^c$ is the corporate bond rate in dollars? – night_owl89 Aug 24 '18 at 13:24