Question

ToysRGreat ($-based, located in Las Vegas) is completing a new assembly plant outside of Berlin, Germany. ToysRGreat expects to pay the final construction payment of amount of € 1,000,000 in three months. The current bid-ask quotes for the spot exchange rate are €0.5682-0.5714/$. The quotes for the three-month forward are € 0.5495-0.5525/$. Three-month Germany and U.S. interest rates are respectively 2.1-2.0% and 3.0-2.9% per annum, compounded quarterly. Note that the borrowing and lending rates (in that order) are presented for each currency. Three months later the $ is quoted at € 0.5236-0.5263 /$.

Using the above information to answer Problems # 1, # 2 and #3 ( PLEASE SHOW ALL WORK)

1 . If ToysRGreat uses forward hedge, how much has the forward market hedge costed (benefited) the company?

2 . If ToysRGreat uses money market hedge, how much has the MMH costed (benefited) the company?

3 . Which hedge is a better choice for the company today and why?

PLEASE SHOW ALL WORK

Answer 1

1) For forward hedge, the company has to buy the Euro forward contract for 1 million Euro at 3 month forward rate of Euro 0.5495/$

The totol dollar amount the company has to pay = Euro 1 million / Euro 0.5495/$ = $1.819836 million

Since after 3 months the Euro amount could have been purchased at  Euro 0.5236/$, total dollar amount would have been =Euro 1 million / Euro 0.5236/$ = $1.909855 million

So, the company benefitted by = $1.909855 - $1.819836 million or $90018.64

2) In Money market hedge (MMH), the company has to borrow $ , convert it to Euro and deposit in Euro such that the final maturity amount is Euro 1 million

Amount that the company has to deposit in Euro today (at 2% p.a.) = Euro 1 million/(1+0.02*3/12) = Euro 995024.88

Amount required to be borrowed in Dollars today (at 3% p.a.) = Euro 995024.88/ Euro 0.5682/$ = $1751187.74

Amount to be repaid at maturity = $1751187.74* (1+0.03*3/12) =$1764321.65

If the company hadn't done the MMH, the amount to be paid = Euro 1 million / Euro 0.5236/$ = $1.90985485 million

So, the company benefitted by = $1,909,854.85 - $1,746,321.65 or $145533.20

3) The Money market hedge is a better choice as the savings is higher in the Money market hedge (net dollar outflow at the end of 3 months is less)