Question

XYZ Ltd, a UK company, is due to pay 360,000 NAf(Dutch guilders) in 3months’ time to BIVA a supplier in the Netherlands. The relevant rates are as follows:

                                     Money market rates (%per year)

                                     Deposit            Borrowing

UK                                   4%                 10%

Netherlands    5%                  9%

Spot rates, NAf/₤: 2.7200 -2.7350

1. Demonstrate how XYZ Ltd can use the money market to hedge the currency risk.

Assuming the funds are obtained by borrowing sterling calculate the sterling cost of the transaction in three months’time.

2. If the bank can offer a three month forward contract, the price is NAf/₤: 2.8000 – 2.8200, which strategy is better? (compare to the answer in part a)

3. Any other hedging strategies recommend?

Answer 1

a. Deposit present value of NAf at 5% for 3 months = Amount Payable / (1 + (Netherlands Deposit rate/4)) = 360000 / 1.05 = NAf 355555.56

Take Loan amount equal to present value of NAf at 2.7200= NAf 355555.56 / 2.72 = Pound 130718.95

Repay pound Loan after 3 months at 10% for 3 months = 130718.95 * (1 + 10%/4) = Pound 133986.93

Sterling Cost of Transaction = Pound 133986.93

b. Cost in Forward rate contract = Payable / Bid rate = 360000 / 2.80 = Pound 128571.43

Forward Rate Agreement is recommended as the cost under FRA is lower than Cost under Money market hedge

c. There few other strategies one can follow to hedge against future exchange rate

a. Call Option (Right to Buy NAf at strike rate with premium payable initially)

b. Buy Currency Futures Contract

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