Question

Assume the following information:

180-day U.S. interest rate = 5%

180-day British interest rate = 7%

180-day forward rate of British pound = $1.30

Spot rate of British pound = $1.24

Assume that Reviera Corp. from the United States will receive 1,400,000 pounds in 180 days. Showing and explaining all workings, determine whether it would be better off using a forward hedge or a money market hedge.

Answer 1

Amount received in 180 days using forward hedge = Amount receivable*Forward rate

= 1,400,000*1.30 = $1,820,000

Under money Market hedge:

Borrow Pounds Today = 1,400,000/(1+7%*180/360) = Pounds 1,352,657.00

Convert into USD today 1,352,657*1.24 = $1,677,294.68

Invest for 180 days in USD = 1,677,294.68(1+5%*180/360) = $1,719,227.05

Amount received after 180 days in Pounds will be used to pay off the loan

Hence, a forward hedge is better since higher amount after 180 days