Use the following to answer questions 14 - 16: PQR Associates will owe EUR 100,000 in...

Use the following to answer questions 14 - 16: PQR Associates will owe EUR 100,000 in one year. It is concerned about appreciation of the EUR and is considering possible hedging techniques. The following market and exchange conditions apply: One Year Forward Rate EUR Interest Rate US Interest Rate USD 1.20 5% 8% Call Option Exercise Price Call Option Premium Today’s Spot Rate USD 1.20 USD .03 USD 1.18 PQR has forecasted exchange rates and has developed the following probability distribution for the expected 1 year exchange rate: 1 Year Exchange Rate USD 1.16 USD 1.22 USD 1.24 Probability 20% 70% 10%

If PQR hedges with a Money Market Hedge, what is the cost of their payables in 1 year?

USD 122,200

USD 121,371

USD 120,000

USD 117,000

Expert Solution

Here the foreign currency payment has to be made after a defined period of time (one year), therefore the following steps have to be taken to hedge currency risk via the money market:

Borrow the domestic currency in an amount equivalent to the present value of the payment.
Convert the domestic currency into the foreign currency at the spot rate.
Place this foreign currency amount on deposit.
When the foreign currency deposit matures, make the payment.

Accordingly,

Borrow U.S. dollars in an amount equivalent to the present value of the payment, or EUR 95238.0952 (i.e. EUR 10,000 / [1 + 0.05). At the spot rate of 1.18, this works out to a loan amount of US$112380.95238
Convert this USD amount into euros at the spot rate of 1.18, which from step 1 is EUR 98238.0952.
Place EUR 95238.0952 on deposit at the 5% annualized rate for one year. This will yield exactly EUR 10,0000 when the deposit matures in a year.
The total amount repayable of the US$ loan including interest (8% annual) is US$121371.43

Therefore the cost of payables in 1 year is USD 121,371

ekkarill92 answered 1 year ago

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