Question

1. Forward versus Money Market Hedge on Receivables. Assume the following information:

                180‑day U.S. interest rate = 1.5% per 180 days or 3% per year compounded semi-annually

                180‑day British interest rate = 1% per 180 days or 2% per year compounded semi-annually

                180‑day forward rate of British pound = $1.32

                Spot rate of British pound = $1.33

      Assume that Riverside Corp. from the United States will receive 200,000 pounds in 180 days. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated revenue for each type of hedge.

Answer 1

Determination of Revenue under the Forward Hedge

Given

Forward Rate : 1 Pound = $ 1.32

Receivable amount after 180 days = 200000 Pounds

2,00000 Pounds are Converted into USD by using Forward Rate

1 Pound = $ 1.32

2,00000 Pound = $ 1.32*2,00000

2,00000 Pound = $ 264000

The Proceeds we can receive under the Forward Hedge is $ 264000.

Determination of Revenue under Money Market Hedge

Step 1: We are having a receivale of 2,00000 Pounds in 180 days create a liability of Present value of 2,00000 Pounds to eliminate Foreign Exchange risk

British Rate of interest rate for 6 months = 1%

Present value of 200000 pounds = Future value / ( 1+i)

= 200000 / (1.01)

= 198019.8019 Pounds

Hence we are required to borrow 198019.8019 Pounds

Step 2: Convert the Borrowed Amount into USD

  Spot Rate : 1 Pound = $ 1.33

198019.8019 Pounds = $ 1.33* 198019.8019

= $ 263366.34

Step 3 : Invest $ 263366.34 in USA at 1.5% for 6 months

Step 4: Value of the Investment after 6 months

  Future Value = Present value ( 1+i)^n

= $ 263366.34( 1+1.5%)

= $ 263366.34( 1.015)

= $ 267316.84

Hence the value of the investment after 6 months is $ 267316.84

Step 5 : Computation of loan balance after 6 months

Loan Outstanding balance = Borrowed Amount( 1+i)

= 198019.8019( 1+1%)

= 198019.8019( 1.01)

= 200000 Pounds

Step 6 : We will receive 200000 pounds after 6 months and repay the loan Amount

The Proceeds we can receive under the Money Market Hedge is $ 267316.84

Method	Amount received
Forward Hedge	$264,000
Money Market Hedge	$267,316.84

Since the Proceeds are higher in Money market hedge,i would be better off by opting money market hedge.

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