Question

Assume the following information 180 day US interest rate = 8% 180 day British interest rate = 9% 180 day forward rate of British pound = 1.50 Spot rate of British pound = 1.48 Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180 days. Would it be better off using forward hedge or a money market hedge? Substantiate your answer with estimated revenue for each type of hedge and show all work.

Answer 1

For forward hedge a firm will receive 400,000($1.50) = $600,000 in 180 days. If money market hedge is used by ht firm, it will borrow (400,000/$1.09) = 366,972 pounds that is to be converted to US dollars and invested in U.S. In 180 days 400000 pounds received will pay off this loan. 366972 pounds borrowed converted to about $543,119 (computed as 366,972 × $1.48), when invested at 8% interest will become accumulate to be worth about $586,569. In contrast, firm will receive $600,000 in 180 days by using forward hedge, or 586,569 in 180 days using the money market hedge. Thus, forward hedge is advisable.