Suppose True Security decides to hedge its exposure. Having recently learned about forwards you suggest that...

Suppose True Security decides to hedge its exposure. Having recently learned about forwards you suggest that True Security enter into a forward contract to fix the ¥/$.

a) You see the following 90 days (3 months) forward bid and ask rates on ¥/$:

Spot 113.0880 (Bid) 113.8290 (Ask)

Forward 113.0573 (Bid) 113.7988 (Ask)

At these rates what will be the final amount that True Security receives in dollars in 3 month time?

b) Your colleague suggests an alternative hedging strategy. She says: “We know that we’ll receive ¥2.655 billion in 3 months (¥2.95 billion minus the 10% payment). Why don’t we borrow Yen at the current interest rates from the bank today such that we’ll have enough to pay them back in 3 months when we get paid. We’ll need to borrow: ¥2.655 billion/ (1+interest rate). We can then immediately convert this money into dollars and invest it at the current US interest rates for 3 months. At the end of 3 months, we receive the ¥2.655 billion payment from the Japanese manufacturing firm and use it to pay back the bank. We’ll have the US dollar investment at the end of 3 months and we won’t be exposed to any exchange rate risk.”

What your friend describes is what’s known as a ‘money market’ hedge. You can evaluate whether this hedging strategy will lead to a higher payoff for True Security than a forward hedge. Suppose you see the following borrowing/lending rates for the Yen and the dollar:

USD rates 0.67% (Bid) 0.92% (Ask)

YEN rates 0.13% (Bid) 0.20% (Ask)

Note that these are annualized rates (3 month rate would 90/360*rate) and that the rip-off rule also applies to interest rates! What will be the final payoff if you implement the money market hedge? How does it compare to the forward hedge?

c) The interest rates quoted above are for large financial institutions with good credit. Assume that True Security has to pay 50bps above the rates quoted when they borrow money. Also assume that True Security earns 30bps below the rate quoted when they invest (or lend) their own money. How do you answer to b) change?

Expert Solution

jeff jeffy answered 2 years ago

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