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.

1. State which currency Boeing should borrow and which to invest.

2. Calculate how much Boeing should borrow or invest.

3. 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

ANS 1

The simple rule is : To sell receivables & To buy payables.

Accordingly, in money market hedge, as Boeing will receive money in £, we will borrow £

ANS 2 :

Since the maturity value should be the same as receivables, we first calculate, present value of pound receivables

that is, £15,000,000 / (1+0.0175) = £14,742,014.74

ANS 3 : TRANSACTIONS TO BE DONE

step 1: borrow pounds :   £ 14,742,014.74

step 2 : convert £14,742,014.74 into dollar at spot rate

£14,742,014.74 x 1.35 = $19,901,719.90

step 3 : Invest $19,901,719.90 in US at 3.25%

step 4 : Collect 15,000,000 from British Airways & use it to repay the pound loan.

step 5 : Receive dollar value on maturity =  $19,901,719.90 ( 1 + 0.0325) =$20,548,525.80

This is the guaranteed dollar that Boeing will receive.

CASH FLOW TABLE

TRANSACTION CASH FLOW AT MATURITY

1. BORROW POUNDS   £14,742,014.74 - £15,000,000

2. BUY DOLLAR SPOT WITH POUNDS $19,901,719.90

- £14,742,014.74

3. INVEST IN US $19,901,719.90 $ 20,548,525.80

4. COLLECT POUND RECEIVABLE £15,000,000

NET CASH FLOW 0 $20,548,525.80

Go through it, Any doubts, please feel free to ask, Give positive feedback, Thank you