Question

(6)Consider the following information:

     90-day US interest rate………………………………...2.5%

     90-day UK interest rate ……………………………....3.0%

     90-day forward rate for the pound…………………...$1.50

     Spot rate for the pound……………………………….$1.52

   

(a)Assume that CSI company based in the US will receive 1,000,000 pounds in 90 days, would it be better off using the forward hedge or money market hedge? Substantiate your answer with appropriate quantitative evidence.

(b)Assume that the same CSI company will need 1000,000 pounds in 90 days and wishes to hedge its payables position. Would you recommend a forward hedge or a money market hedge? Explain your answer with relevant quantitative support.

Answer 1

Answer a:

1st option Forward cover:

US Company receivable 10,00,000 pounds in 90days..If we sale 10,00,000 pounds forward for 90days @ $1.50 per pound ,getting = $(10,00,000 * 1.50)

= $ 15,00,000

2nd option Money Market Hedge

Step 1: Borrow present value 10,00,000 pound @ 0.75% (3%/360days * 90days)

= 10,00,000 pound / 1.0075

= 9,92,556 pound (approx)

Step 2: Sale this amount spot @ $1.52/pound getting

= $(9,92,556 * 1.52)

= $ 15,08,685

Step 3: Invest $ 15,08,685 @ 0.625% (2.5%/360*90)

Inflow after 90days = $(15,08,685 * 1.00625)

   = $ 15,18,114 (approx)

Decision : As the $ inflow is more incase of Money Market Hedge so it is advisable to prefer Money Market Hedge.