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

Solution :

Current exchange rate = $0.404 / Ringgit Interest rate = 4% in USA, 3 % in Malaysia

90 Days forward rate = $0.404/ Ringit

Santa Barbara will need 500,000 ringgit in 90 days.

So the company has two option either to go for money market hedge or use forward hedge

We can calculate the cost of both the options and then take the decision based on that

Option 1: Forward hedge

If the company goes for forward hedge then USD required = 500,000 * Forward rate = 500,000 * 0.400 = $200,000

Option 2: Money Market Hedge

In this option, the company will borrow money and convert that to ringgit and then invest that in Malaysian interest rate and then pay 500,000 ringgit

Malaysian interest rate = 3% per annum so 90 days interest = 3% *90/365 = 0.7397%

So the company will need 500,000/ (1+ 0.007397) ringgit today because this amount invested at 3% will become 500,000 in 90 days

Amount needed = 500,000/ (1+ 0.007397) = 496,328.5

Equivalent USD at current spot rate = 496,328.5 * 0.404 = 200,516.7

Interest rate in US for 90 days = 4%*90/365= 0.9863%

So borrowed amount 200,516.7 wiill become 200,516.7 *(1+0.09863) = 202,494.4

So if the company uses money market hedge then the will be effectively paying 202,494.4 USD as compared to forward hedge where they are paying 200,000 USD only

So forward hedge is better option