Question

Star Industries Ltd would like to hedge its US$10 million payable to a US chip manufacturer, which is due in 90 days. Star approached various banks and obtained the following foreign exchange rate quotes as well as interest rates.

	BID	ASK
SGD/USD spot rate	0.7120	0.7140 (Note: US$1 per SGD$1 )
SGD/USD forward rate	0.7150	0.7175
US$ 90-day interest rate	0.75%	0.80%
S$ 90-day interest rate	0.5%	0.55%

(a) If Star were to hedge forward its US$10m payable, analyse and compute the amount in Singapore dollars that the firm needs today.

(b) Jack Tan, a recent finance graduate working in Star, suggested an alternative. Instead of doing a forward transaction, he suggested that the firm converts Singapore dollars into US dollars today and deposit the US dollars in a US dollar deposit account. Analyse and compute the amount of Singapore dollars that the firm needs today if it follows Jack’s suggestion.

(c) Assess which alternative is better for the firm.

(d) Examine and discuss whether there are any opportunities for arbitrage profits and their feasibility.

Answer 1

a) if the Forward hedge is used, the company will require to pay 1 SGD to get USD 0.7150 (forward bid rate) , So for a total amount of USD 10 million , the company will require SGD= 10 million /0.715 = 13.986014 million SGD after 3 months

The company can invest SGD at a rate of 0.5% p.a.(assuming that the bid and ask quotes are p.a. basis)

So, amount needed today in SGD = 13.986014 million / (1+0.005*90/360) =SGD 13,968,553.29

b) Amount required after 3 months = USD 10 million

USD investment can be done at 0.75% p.a.

So, amount required in USD today = 10/(1+0.00075*90/360) = USD 9,998,125.35

This amount can be obtained today by converting SGD to USD at the spot bid rate

So, amount needed today in SGD = 9998125.35/0.712 =SGD 14,042,310.88

c) The first alternative is better for the firm as the amount required in SGD today to pay the liability is less. Forward hedge is better.

d) Buying USD is better in Forward market. So arbitrage steps may be as follows

Today :

i) Borrow USD 100 at 0.80% p.a. for 3 months. Payable amount after 3 months = 100*(1+0.008*90/360) = USD 100.2

ii) Convert this to SGD at spot rate by paying USD 0.714 per SGD to get 140.056 SGD

iii) Invest SGD for  3 months at 0.5% p.a. to get SGD 140.056*(1+0.005*90/360) = SGD 140.23 after 3 months

iv) Sell SGD and buy USD forward for an amount of SGD 140.23 at the rate of 0.7150 USD/SGD

After 3 months

Get SGD 140.23 from the bank, sell it using forward to get USD 140.23*0.715 = USD 100.27

Pay off the USD loan of USD 100.20 and take the $0.07 as arbitrage profit