In: Finance
Assume that a U.S. firm expects to make a payment of SF3,500,000 in 6 months and wants to execute a money market hedge. The following information is available:
U.S. borrowing interest rate = 5%; U.S. lending interest rate = 4%;
Swiss borrowing interest rate = 8%;Swiss lending interest rate = 6%;
Spot rate is $0.95/SF; The U.S. firm's weighted average cost of capital (WACC) is 10%.
Explain very well if the U.S. firm intends to use the money market hedge to cover the payment of SF2,500,000, what shall it do and what will be the total cost in USD in 6 months?
Money Market Hedge Amount = SF2,500,000
Step 01 :
US Firm Invest equivalent amount in Swiss Bank as high-interest rate available there.
Amount Required in Present Value = Amount / ( 1+ Swiss lending interest rate )
Swiss lending interest rate = Annual Swiss lending interest rate/ 2 = 6% / 2 = 3%
Amount Required in Present Value = Amount / ( 1+ Swiss lending interest rate )
= 2,500,000 / ( 1+3%) = SF 2427,184.47
Step 02 :
Now US Firm needs to Invest SF 2427,184.47 today in Swiss Bank.
So Equivalent Dollar Amount needs to transfer = Amount * Spot rate $/SF
=SF 2427,184.47 * $0.95/SF
= $ 2305,825.24
Step 03 :
So US Firm needs to Borrow this amount today from US Market to transfer same in Swiss Frank.
Borrowing Rate in 06 Month for US Firm = WACC / 02 = 10% / 02 = 5%
Total Amount Payable after 06 Months = Amount * ( 1 + rate) = $ 2305,825.24 * ( 1+5%) = $ 2421,116.50
Ans : Final Amount after 06 Months Payable by US Firms = $ 2421,116.50 ( This amount is fixed irrespective of any movement in Exchange rate)