Question

Suppose AAPL has a 2 billion USD worth of profit it is expecting to collect from its subsidiary in Hong Kong in 12 months. How can AAPL hedges with a money market hedge if the current exchange rate is at $0.1255 per HKD and the interest rate in Hong Kong is 2.5% and the interest rate in the US is 3.5%? How much USD will AAPL actually get from this hedge?

Answer 1

AAPL has USD receivables worth $ 2 billion in 12 months (1 year) time.Further, current exchange rate = $0.1255 / HKD, HKD Interest Rate = 2.5% and US interest rate = 3.5 %

A money-market hedge will ensure that the 12-month exchange rate will adhere to the principles of covered interest parity. In other words, the exchange rate after 12 months under a money market hedge will equal the exchange rate predicted by the covered interest parity (CIP) relationship.

Expected Exchange Rate as per CIP = 0.1255 x [(1.035) / (1.025)] = $ 0.12672 / HKD

A money-market hedge can be implemented as described below:

- Borrow $ equal to the present value of the $ receivable worth $ 2 billion after 12 month

- PV of Expected $ Receivables = 2000 / (1.035) = $ 1932.37 million

- Convert this PV borrowing into HKD at the current exchange rate to yield (1932.37/0.1255) = HKD 15397.35 million

- Invest this converted value in Hong Kong at the HKD rate of 2.5 % to yield (15397.35 x 1.025) = HKD 15782.28 million

- After 12 months, AAPL will pocket this HKD investment proceeds and repay the original $ borrowing with the $ 2 billion received at that time, thereby exchanging $ 2 billion for HKD 15782.28 million

- Effective Exchange Rate = (2000 / 15782.28) = $ 0.12672 / HKD