Question

Assume the following information:

90?day U.S. interest rate = 4%

90?day Malaysian interest rate = 3%

90?day forward rate of Malaysian ringgit = $.400

Spot rate of Malaysian ringgit = $.404

Assume that the Santa Barbara Co. in the United States will need 500,000 ringgit in 90 days. It wishes to hedge this payables position. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated costs for each type of hedge.

Answer 1

	90?day U.S. interest rate = 4%
	90?day Malaysian interest rate = 3%
	90?day forward rate of Malaysian ringgit = $.400
	Spot rate of Malaysian ringgit = $.404
	the Santa Barbara Co. in the United States will need 500,000 ringgit in 90 days
1	Hedging through forward hedge
	Company will get 500,000 ringgit after 90 days for,
	= 500,000 x $ 0.400
	= $ 200,000.00
2	Hedging through Money market hedge
	Borrow necessary USD @ 4% p.a. and buy Malaysian ringgit today @ spot rate of $ 0.404 and invest it in Malaysian market @ 3% p.a. for 90 days and pay off the liabilities using arised after 90 days using realised amount
	We need to find amount need to invest today in Malaysia to get 500,000 ringgit after 90 days
	Present value of 500,000 ringgit when i=0.75% (i.e. 3% x 90/360), n=1
	PV factor for $ 1 will be		= 1 / (1 + 0.0075)^1
			= 0.992555831265509
	require investment amount of ringgit today will be
	= 500,000 x 0.99255831265509
	=$ 496279.156327545
	USD required for buy 496279.156327545 ringgit today
	= 496279.156327545 x 0.404
	=$ 200496.779156328
	Borrow $ 200496.779156328 @ 4% for 90 days
	Interest amount will be
	=200496.779156328 x 4% x 90/360
	= $ 2,004.96779156328
	Total USD cost if hedging done through money market
	=$ 200496.779156328 + $ 2,004.96779156328
	=$ 202,501.746947891
	Hedging using forward contract is best option and company should opt for forward exchange