Question

Suppose Boeing Corporation exported a Boeing 787 to British Airway (BA) and billed BA £15 million payable in one year. The money market rates and foreign exchange rates are given as follows:

The U.S. one-year interest rate: 3.25% per annum

The U.K. one-year interest rate: 1.75% per annum

The spot exchange rate: $1.35/£

Show the money market hedge strategy that the company can use to hedge the company’s transaction exposure. Be sure to include the following.

State which currency Boeing should borrow and which to invest.

Calculate how much Boeing should borrow or invest.

State the transactions needed to be done and the cash flows at t=0 and t=12 by constructing a cash flow table.

Answer 1

Boeing has exported a Boeing 787 to British Airways

As Boeing is an exporter, he has to borrow pounds and has to invest dollars

Amount to be received = £15,000,000 after a year

Step 1 : Since maturity value of borrowing should be equal to pound receivable

pound to be borrowed = £15,000,000/(1+0.0175) = £14742014.74 pound

After a year, with interest, Boeing has to pay £15,000,000 which company will receive from British airways

Step 2 : convert £15,000,000 pound into dollar at spot rate $1.35= 1£

£15,000,000 x 1.35 = $20,250,000

Step 3 : invest $20,250,000 into US @ 3.25%

Step 4 : collect £15,000,000 from British Airways and repay the pound loan

Step 5: After a year, receive dollar amount with interest = $20,250,000 (1+0.0325) = $20,908,125

This is the guaranteed dollar proceeds.

Cash flow table                        current cash flow (t=1) cash flow at maturity (t=12)

1. Borrow pounds                        £14,742,014.74 -£15,000,000
2. Buy dollar spot                        $20,250,000
3. With pounds                            £14,742,014.74
4. Invest in the US                        $20,250,000                                 $ 20,908,125
5. Collect pound Receivable                                                             -£15,000,000

Net cash flow                                       0 $ 20,908,125

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