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A United Kingdom firm is planning to hedge an import payment of USD 10 million dollars...

A United Kingdom firm is planning to hedge an import payment of USD 10 million dollars due in 9 months (i.e. the firm will expect to pay the US $10 million in 9 months-time). The spot rate is 1 UK = 1.25 USD. Note: UK = UK pounds. USD = US Dollars. The 9-month forward rate is 1 UK = 1.2575 USD. The nine-month interest rate for borrowing (and lending) in the United Kingdom (UK) is 1.00% p.a. and in the United States (US) is 2.60% p.a. respectively. All interest rates are continuously compounded rates. Required: What is the best way for the company to hedge its future USD payment or cash outflow? Of the two possible alternative options to hedge the USD payment how much better off in UK pounds are you under the best option at time t = 9 months hence? Assume the firm can borrow or lend UK pounds and / or US dollars at the interest rates quoted above and also transact at the quoted spot and forward rates. If necessary state any other assumptions you make.

a. option one .. option two .. b. How much better off in UK pounds are you under the best option at time t = 9 months hence?

Expert Solution

There are two options available:

1. Hedging through Forward contracts

2. Money market hedging

Opton 1: Hedging through Forward contracts

Forward rate, F: 1 UK = 1.2575 USD.

Hence, total outflow towards import payments in terms of UK pounds = Payable / F = USD 10,000,000 / (USD 1.2575 / UK) = UK 10,000,000 / 1.2575 = UK 7,952,286

Option 2: Money market hedging

No arbitrage forward rate under money market, FNA = Se(rUS - rUK) x t = USD 1.25 x e(2.60% - 1.00%) x 9/12

= USD 0.9526 / UK

Hence, the total outflow towards import payments in terms of UK pounds = Payable / FNA = USD 10,000,000 / (USD 0.9526 / UK) = UK 10,000,000 / 0.9626 = UK 10,497,358

Hece, the answers should be:

a. option one: UK 7,952,286

option two: UK 10,497,358

b. How much better off in UK pounds are you under the best option at time t = 9 months hence?

You are better of in option one and you are better off by 10,497,358 -7,952,286 = UK 2,545,072 under the best option at time t = 9 months hence

jeff jeffy answered 1 year ago

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