Question

I am a US chocolate importer who is importing Belgian chocolate from Belgium worth € 1 million and the amount is due in 360 days. I want to hedge my Belgian euro payables using a money market hedge and obtain the following quotes from my banker:

Spot rate is: $1.1000 – $ 1.1100 / €

The Belgium interest rates are:                  3.0 % - 3.4 % annually and

US interest rates are:                                   2.1 % – 2.5 % annually.

Using a money market hedge and bid-ask spreads, what are my $ payables in 360 days?

	a.	$1,094,660.20
	b.	$1,096,044.49
	c.	$1,077,669.90
	d.	$1,104,611.65

Answer 1

Step 1: Borrow the $ equivalent of present value of € 1 Million

Present value of € 1 million = 1000000/(1+3%) = € 970,873.79

Spot rate = $1.11 / €

Equivalent $ = € 970,873.79*1.11 = $1,077,669.90

Step 2: Borrow $1,077,669.90 at 2.5% for 360 days

$ value after 360 days = $1,077,669.90* (1+2.5%) = $1,104,611.65

$ payables in 360 days = $1,104,611.65 (option d)

Note:

In Money market hedge involving payables, strategy is

o to borrow in domestic currency equivalent to the present value of the foreign payable and

o this equivalent domestic currency borrowed is converted to foriegn currency using the spot rate and

o the resultant foriegn currency is then invested

o which is used to settle the foriegn currency payable on the due date.

In the given question,

a. Equivalent amount is borrowed in USD, hence rate of 2.5% is taken (2.1% not taken as it represents deposit rate)

b. Spot rate of 1.11 is used since Euro is bought against the USD (if Euro is sold, rate of 1.10 would have been taken)

c. € are deposited at 3% (and not 3.4% which is the borrowing rate).