Question

Which of the following statements is correct for a U.S. importing firm that owes GBP 1,000,000 payable in three months? Assume the company's WACC is 12% p.a. and the U.K. deposit rates are 8% p.a. The current spot rate is USD1.45/GBP and the 3-month forward rate is USD1.50/GBP.

		The U.S. importer can lock the payable at the cost of USD 1,450,000 using a forward contract
		The forward hedge is more expensive than the money market hedge for the importer
		Using a money market hedge, the U.S. importer needs to invest GBP 1,000,000 today
		The U.S. importer can lock the payable at the cost at USD 1,464,216 using money markets
		The U.S. importer can lock the payable at the cost at USD 1,412,338 using money markets

Answer 1

Solution:-

There are two ways for US importer to lockin the liability under the import trade and they are as follows:

(a)

Using forward contract, the importer can enter into a forward agreement to buy 1,000,000 GBP after 3 months at the rate of $1.45 per GBP. This way, his liability gets locked in at $1,450,000

(b)

In a money market hedge, the importer would buy enough pounds today which invested in the UK at the rate of 8% p.a. yield GBP 1,000,000 after 3 months. The required level of pounds required to be bought today are as follows:

Required GBP today= 1,000,000*100%/[100% + (8%*3/12)] = GBP 980,392.16

Therefore, GBP 980,392.16 invested today in the UK at 8% p.a. interest will give GBP 1,000,000 after 3 months which can be used to pay for the import bill.

Now, the dollar cost of the money market hedge is as follows:

Cost of hedge= (980,392.16*Current spot rate)*[1+ WACC*(3/12)] = 980,392.16*1.45*[1+ 12%*(3/12)]= $1,464,216

Therefore, based on above calculations, we can say the cost of forward hedge is $1,450,000 whereas the cost of money market hedge is $1,464,216. Further, money market hedge is more expensive than the forward hedge. Also, using money market hedge the importer is investing only 980,392.16 GBP today and not 1 million GBP.

Therefore, the correct statements are first and fourth statements.