Question

A Firm, located in the United States, has an accounts payable obligation of ¥750 million payable in one year to a bank in Tokyo. The current spot rate is ¥116/$1.00 and the one year forward rate is ¥109/$1.00. The annual interest rate is 3 percent in Japan and 6 percent in the United States. XYZ can also buy a one-year call option on yen at the strike price of $0.0086 per yen for a premium of 0.012 cent per yen. What is the future dollar cost of meeting this obligation using the forward hedge?

Answer 1

Accounts Payable = ¥ 750 million, Forward Rate = ¥ 109 / $

If the firm uses a forward hedge, it essentially implies that the firm buys a forward contract to lock in the exchange rate at which the firm will pay off its obligation in a years time. Under this forward contract, the firm agrees to pay off its yen payable at the forward exchange rate of ¥ 109 / $ irrespective of the actual exchange rate prevailing then.

Therefore, Dollar Cost of Obligation under Forward Contract = 750 / 109 = $ 6.881 million