Question

1. Forward & Money-Market Hedge: Your company will RECEIVE £100 million in one year time from a British customer. You observe the following exchange rates and interest rates between Canada and the U.K. in the capital market:

Spot exchange rate	S0,$$ = 1.9055
90-day forward rate	F360,$$ = 2.0055
Canadian annual risk-free interest rate	i$ = 4%
U.K. annual risk-free interest rate	i$ = 6%

You can either use a forward contract or money-market instruments to hedge your £ exposure. Which instrument (forward or money-market) would you choose to hedge your £ exposure? Depending on what you choose, what would be your Canadian $ RECEIVABLE in one year time?

Answer 1

(1)   Forward Contract:

Enter into a Forward Contract to SELL GBP 100 Million after 1 year.

Amount Receivable after 1 year = GBP 100 Million*Forward Rate of C$/GBP = 100 Million*2.0055 = C$200.55 Million

(2)   Money Market Hedge:

GBP are RECEIVABLE. Therefore, we need to create a liability in GBP.

Borrow GBP and Invest in C$.

STEPS:

Now,

(1)   Borrow GBP for 1 year so that, GBP payable after 1 year along with interest will be GBP 100 Million. Therefore, Borrow 100,000,000/[1+(0.06)] = GBP 94339622.6415

(2)   Convert GBP into C$ at Spot Rate and Receive 94339622.6415*1.9055 = C$ 179764150.943

(3)   Invest C$ 179764150.943 for 1 year.

After 1 year,

(4)   Receive GBP 100 Million

(5)   Repay the borrowings along with interest. 94339622.6415+6% = GBP 100 Million

(6)   Realize the Investments along with interest. 179764150.943+4% = C$ 186954716.98

Amount Receivable = C$ 186,954,716.98 = C$ 186.95 Million

As Forward Contract Option has HIGHER receivable amount, it should be chosen and Receivable will be $200.55 Million