Question

Trance Corp., a US based firm, has just concluded negotiations for sale of a powder coating machine to Regency, a British firm, for £1,200,000. The sale is made in March with payment due three months later in June. As the CFO of Trance, you are comparing remaining unhedged with using either the forward market hedge or the money market hedge to manage this risk. The following information is available to you. The spot rate is GBP/USD 1.4640, whereas the 90-day forward exchange rate is GBP/USD 1.4540. The finance team of Trance has forecast the spot rate in 90 days to be $1.4600/£. Trance’s weighted average cost of capital (WACC) is 12%. Annual eurosterling deposit and borrowing rates are 8% and 10% respectively. Assuming the 90-day exchange rate forecast is correct and Trance reinvests all the cash generated back in the business, identify the best alternative. [19 mark

Answer 1

	Money Market hedge
	Trance due to receive £1200,000 in 3 months
1	Borrow £ now for 3 months
	(Interest 10% *3/12=2.5%)
	X*1.025=£1200000
	X	1170732
2	Convert £ into $ at spot
	Spot rate (GBP/USD 1.4640)
		$799680.3	(1170732/1.4640)
3	Deposit $ for 3 months
	Depost	$823671	($799680.3*1.03)
	Interest 12% for 3 months=12%*3/12=3%
	Since Weighted average Cost of Capital is 12%, use deposit rate 12%
	Forward Rate
	GBP/USD 1.4540
	Trance due to receive £1200,000 in 3 months
	Receipt	$825309	(1200000/1.4540)
	We are receiving more in forward rate, use Forward rate instead of money market hedge