Question

10) Suppose that S0 $/₤ = 1.25$/₤, F1 $/₤ = 1.20$/₤, i₤ = 11.56% and i$ = 9.82%. You are to receive 100,000₤ on a shipment of goods in one year. As a US-based firm you want to avoid foreign exchange risk.

A) Form a money market hedge that replicates the payoff on the forward contract by using the spot currency and the Euro-currency markets. Identify each contract in the hedge. Does this hedge eliminate the foreign exchange risk?

Answer 1

1. The basic idea behind a money market hedge is to lock the current spot rate for payables or receivables in a foreign currency.

2. In the given question, the US exporter has £ receivables after 1 year, so it runs the risk of £ falling in the future. In order to hedge in money market, the exporter will borrow the present value of the foreign currency receivable and then convert the borrowed amount in the home currency and invest such home converted home currency in the domestic market. When the loan matures and becomes due for payment, the exporter can do so using the foreign currency that was receivable from the customer.

Therefore, in the question, a US exporter has £100,000 on a shipment in one year i.e. 12 months.

Spot Rate (So)= $/£= 1.25$/£

Forward Rate (F1)= $/£= 1.20$/£

i£= 11.56, i$= 9.82%

Step 1: Firstly, the exporter will borrow the present value of the £100,000 at 11.56%.
Present Value = £100,000/1.1156 = £89637.86

Step 2: Now, convert this amount into home currency i.e in $ using spot rate.
i.e. £89637.86* 1.25 = $112047.33

Step 3: Invest the dollar amount converted at 9.82 in the domestic market.
i.e. $112047.33* 1.0982 = $123050.38

After 1 year, the amount receivable from the customer will be used to payoff the loan of £100,000 taken in the Step1.

The forward rate is $/£= 1.20$/£
If the exporter relied on the forward rate, then the amount realized by him at the maturity would have been
= 1.20 * 100000 = $120000

But under money market hedge, the amount realized by the exporter is $123050.38

Therefore, the exporter makes reduces his loss by $3050.38 ($123050.38-$120000) and this way he hedged its money against the foreign exhange risk.