Question

1. The European aircraft manufacturer Air Bus will pay $10 million to United Airlines one year from today. The spot rate is $1.20/euro, while the 1-year forward rate is $1.30/euro. The 1-year interest rate in the US is 5%, and the 1-year interest rate in the Euro Zone is 3%.

   1. Air Bus should do a money market hedge because it will cost less than if it used a forward hedge.

   2. Air Bus should do a forward hedge because it will cost less than if it used a money market hedge.

   3. Air Bus should do a money market hedge because it will make more than if it bought the dollars forward.

   4. It does not matter what Air Bus does, because since Interest Rate Parity holds, Air Bus will wind up paying the same amount of dollars regardless of the strategy it uses.

Answer 1

If air bus goes for forward contract

Outflow under forward contract = $10 mln /1.3 = Euro 7.69 mln

If Air bus goes for money market hedge

1) Borrow Euro 7.9365 mln for 1 year @3%

2) Convert euro into $ at spot rate ie 1 Euro = 1.2$

1 Euro = 1.2$

? = $9.5238 mln

Euro = $9.5238/1.2 = 7.9365

3) Invest $9.5238 mln @5% such that it equals to $10 mln after 1 year

Amount to be invest = $10/(1.05)

=$9.5238 mln

4) Pay the Dollar bill

5) Repay the loan with interest

=7.9365(1.03) = Euro 8.17 mln

Thus Air Bus should do a forward hedge because it will cost less than if it used a money market hedge.