Question

1. Forward versus Money Market Hedge on Payables. Assume the following information:

      90‑day U.S. interest rate = 2% per 90 days or 8% per year compounded quarterly

      90‑day Malaysian interest rate = 2.5% per 90 days or 10% per year compounded quarterly

        Assume borrowing and lending rates are the same for simplicity.

      90‑day forward rate of Malaysian ringgit = $0.31

      Spot rate of Malaysian ringgit = $0.30

      Assume that the Santa Barbara Co. in the United States will need 500,000 ringgit in 90 days. It wishes to hedge this payables position. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated costs for each type of hedge.

Answer 1

Forward hedge:

Cost = payable amount*forward rate = 500,000 ringgit*$0.31/ringgit = $155,000

Money market hedge:

Amount required in 90 days = 500,000 ringgit

So, amount required now = 500,000/(1+90 day Malaysian interest rate) = 500,000/(1+2.5%) = 487,804.88 ringgit

Amount required now (in USD) = 487,804.88*spot rate = 487,804.88*0.30 = $146,341.46

Dollar cost after 90 days = USD amount now*(1+ 90 day US interest rate)

= 146,341.46*(1+2%) = $149,268.29

Hedging cost will be lower using money market hedge as compared to the forward hedge.