Question

Alcoa, a U.S. firm, has signed a contract to purchase goods from a manufacturer in Germany for
€5,000,000. The purchase was made in June with payment due six months later in December.
The following market quotes are available:
o The spot exchange rate is $1.20/€
o The six month forward rate is $1.21/€
o The Euro zone 6-month borrowing rate is 7%
o The Euro zone 6-month deposit rate is 5%
o The U.S. 6-month borrowing rate is 6%
o The U.S. 6-month deposit rate is 4%

(a)	Calculate the six-month forward premium/discount for euros. Show your calculations.

(b) If Alcoa chooses to hedge its transaction exposure in the forward market at the
available rates, what will be the required amount in dollars to pay off the accounts
payable in six months? Show calculations to support your answer.

(c)	If Alcoa chooses to hedge its transaction exposure in the money market at the available rates, what will be the required amount in dollars to pay off the accounts

payable in six months? Explain the steps and show calculations to support your
answer. Would Alcoa be better off using a forward hedge or a money market hedge?

(a) forward premium 1.67%
(b) $6,050,000
(c) $6,029,268

can you show me step by step please. The other in chegg was wrong

Answer 1

Part A:-

Computation of Forward Premium or Discount

Since the Aloca is a US Firm its home currency would be US $. If we compare Spot rate and Forward rate it can be seen that the Firm has to pay more US $ (1.21-1.20) for each euro in future. Hence Euro is at Premium.

Since we have to compute Premium of Foreign Currency (Euro) = (Forward Rate - Spot Rate)/Spot Rate *12/n*100

= (1.21-1.20)/1.20*12/6*100

= 1.67%.

Hence Euro is at premium of 1.67%.

Part B

Outflows in US $ if Hedging is done through Forward Contract

The Forward Rate = $1.21/€

Hence total outflow in $ = € 50,00,000 *1.21

= $ 60,50,000

Hence the total Outflow in $ if hedging is done through forward contract is $ 60,50,000.

Part C

Outflows in US $ if Hedging is done through Money Market Hedge

Since after six months the firm is required to pay € 50,00,000 the firm will invest today in germany such amount that after six months that amount including interest will become € 50,00,000/-

Interest rate for Investing in Germany = 5% p,a.

Let amount to be deposit today will be x.

So x + (x*5%*6/12) = 50,00,000

x + 0.025x = 50,00,000

1.025x = 50,00,000

x = 48,78,049 (r/off)

Hence amount to be invested today in € is € 48,78,049/-

We will buy € at spot rate = $1.20/€

Hence total $ required today = €48,78,049 * 1.20

= $ 58,53,659 (r/off)

Since the firm does not have suficient money today it will borrow from local bank.

The interest for borrowing in US = 6% p.a.

After 6 months the firm has repay the loan along with the interest

i.e. $58,53,659 + ($58,53,659*6%*6/12)

= 58,53,659 + 1,75,609

= $ 60,29,268/-

Hence the total outflow in $ if hedging is done through Money Market Hedge would be $ 60,29,268.

Since the Total Outflow in US $ in Money Market Hedge is lower by $ 20,732 (60,50,000-60,29,268) as compare to the toal outflows under Forward Contract hedging.

Hence it is advisable to hedge using Money Market Hedge,

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