Question

An exporter is a UK based company. Invoice amount is $350,000. The credit period is 3 months. Exchange rates in London are:

Spot rate $/£ 1.5865-1.5905

3-month foreward rate $/£ 1.6100-1.6140

Rates of interest in the money market are as Currency Deposit rate and Loan rate at $ 7% 9% respecively and £ 5% 8% respectively .

Required

Show how the exporter can hedge the receivable using a forward contract and a money market contract. Compare the outcomes of the two

Answer 1

Base currency in this question is £

If hedged using forward contract:

Amount Exporter will receive after 3 months= $ invoice amount / ask rate= $350,000 / 1.6140 = £ 216,852.54

If hedged using money market contract,

Implied forward rate = ask rate x (1+borrowing in US) / (1+investing rate in UK)

= 1.5905 x (1+9%x3/12) / (1+5%x3/12) = 1.6062

Amount Exporter will receive after 3 months= $ invoice amount / ask rate= $350,000 / 1.6062 = £ 217,904.44

It is better to hedge using money market instruements