Question

Question 1:

Assume that you provide financial advice to Minelli Enterprises Limited. The company’s management has come to you for guidance over a foreign exchange transaction. The company, based in New Zealand, has sold GBP$ 4,500,000 worth of equipment to a customer in Great Britain. The payment has been deferred for six (06) months. The following information has been provided:
Spot exchange rate = NZD 1.9639/GBP
Six-month forward rate = NZD 1.9613/GBP
New Zealand lending rate = 3.12% p.a.
New Zealand deposit rate = 2.22% p.a.
Great Britain lending rate = 1.22% p.a.
Great Britain deposit rate = 0.86% p.a.
Risk free rate in New Zealand = 0.68% p.a.
Risk free rate in Great Britain = 0.92% p.a.

Required:
5.1 Calculate the expected spot rate in 6 months, assuming the Interest Rate Parity holds between the two countries.
(Round off calculations to four decimals.)
5.2 Calculate the expected value of the sale in New Zealand dollars using the expected spot rate calculated in 5.1 above, assuming they do not hedge.
Based on your result, should the company hedge? Why?
5.3 Calculate the value of the proceeds from the sale if the company enters a forward rate agreement.
5.4 Assuming the company entered a forward market hedge contract, calculate the foreign exchange loss or gain that would be recorded in the books of accounts if the transaction had been recorded in the books at the spot rate at the time of purchase.
5.5 Explain and calculate the net amount receivable by Minelli Enterprises Limited Ltd if money market hedge is used. (Show workings.)
5.6 Based on your calculations above, which alternative would you recommend and why?

Answer 1

5.1 EXPECTED Spot rate in 6 months:

Current Spot rate:NZD1.9639/GBP

NZD Risk Free Interest in 6 months=(0.68/2)%=0.34%

Future Value of 1.9639 NZD after 6 months=1.9639*1.0034=NZD 1.970577

GBP Risk Free Interest Rate in 6 months=(0.92/2)%=0.46%

Future Value of 1 GBP after 6 months=1.0046 GBP

Expected Spot rate:

1.0046GBP=1.970577NZD

(1.970577/1.0046)NZD/GBP

1.9616 NZD/GBP

5.2 Calculate the expected value of the sale in New Zealand dollars using the expected spot rate calculated

Expected Value =4,500,000*1.9616 NZD=NZD$8,827,200

Company should not hedge , because forward rate is lower at 1.9613NZD/GBP

5.3Calculate the value of the proceeds from the sale if the company enters a forward rate agreement.

Proceeds from Sale with Forward rate agreement=1.9613*4500000=NZD$ 8,825,850

5.4 Forward exchange loss =8827200-8825850=$1350 NZD

5.5 MONEY MARKET HEDGE

STEP 1 :Borrow Present Value of GBP4500000 in Britain at 1.22%=4500000/(1+(0.0122/2))=4,472,716 GBP

STEP2: Convert into NZD dollar at current spot rate of 1.9639NZD/GBP

Amount received =4472716*1.9639=NZD 8783967

STEP 3: Invest 8783967 NZD at six monthly interest of (2.22/2=)1.11%

Amount Received at end of six months =8783967*1.0111= NZD$8,881,469

STEP4: Amount of GBP 4500000 received after 6 months will be used to clear the debt in GBP including interest

5.6 The amount received is higher in Money Market Hedge, Money Market Hedge should be used