Question

A US importer has a contractual obligation to purchase €5,000,000 of raw materials in one year from now. The CFO wants to hedge the currency risk by using a money market hedge. Further, he does not want to use any of the company’s current cash to enact this hedge (i.e. he wants to borrow money from either a US bank or a European bank). He asks you to put together an analysis, and lay out the steps to hedge the euro exposure. The current spot rate is $1.1/€, the one year risk free interest rates are 3% and 1.5% in the US and Europe, respectively. The forward rate is $1.13/€. (Show calculations and steps)

a. Is your company long or short euro?

b. From which bank (US or European) should your company take out a loan?

c. What do you do with those loan proceeds to hedge your company’s exposure?

Answer 1

a. US Importer has to pay euro, so he is short on the euro.

b. Since we have to pay in euros, we will take a loan from US Bank and invest in European Bank. So, we get euros after 1 year to repay.

c. Workings

Take a loan from the US Bank

Let the loan amount be x$.

Covert Spot in euros= x/1.1

Invest in European for a year, return = (x/1.1) + (x/1.1)*1.5%. This should be equal to the amount of payment for raw materials.

That is, (x/1.1) + (x/1.1) * 1.5% = 5000,000

(x/1.1) + (x/1.1) * 0.015 = 5000,000

x = (5000,000 * 1.1) / 1.015

x = $54,18,719

Repay after 1 year = x + x*3% = 54,18,719 + 54,18,719 * 3% = $55,81,281

Expense after 1 year will be $55,81,281.