Question

A European company is importing (purchasing) $700,000 of goods in one year. The current spot price is $1.12/€. Risk free rates in the US and Eurozone are 3% and 4%, respectively. The forward rate is $1.09/€. Your CEO wants to implement a money market hedge. This involves borrowing in one currency to purchase the other currency (which you will then invest for one year). What is the amount you are borrowing? Once the money market hedge is finalized a year later, was this hedge more favorable than a forward hedge?

Multiple Choice

A. Borrow 700,000 dollars

No, the money market hedge offered a worse conversion price between euros and dollars.

B. Borrow 606,796.12 euros

Yes, the money market hedge offered a better conversion price between euros and dollars.

C. Borrow 655,725.25 euros

Yes, the money market hedge offered a better conversion price between euros and dollars.

D. Borrow 490,019.61 dollars

No, the money market hedge offered a worse conversion price between euros and dollars.

E. Borrow 470,365.35 euros

No, the money market hedge offered a worse conversion price between euros and dollars.

Answer 1

Payables in one year = $700,000

Under money market hedge, Euro will be borrowed and converted

Into Dollars and invested such that Principal plus interest becomes equal to amount payable on maturity

Amount required to be invested in Dollar = 700,000/(1+3%) = $679,611.65

Amount required to be borrowed in Euro = 679,611.65/1.12

= Euro 606,796.12

Amount paid under forward hedge = 700,000/1.09 = Euro 642,201.83

Yes, money market hedge offered a better conversion price

Hence, the answer is

B. Borrow 606,796.12 euros

Yes, the money market hedge offered a better conversion price between euros and dollars.