Question

American Airlines is trying to decide how to go about hedging $70 million in ticket sales receivable in 180 days. Suppose it faces the following exchange and interest rates.

Spot rate:                                                          $0.6433-42/SFr

Forward rate (180 days):                                    $0.6578-99/SFr

DM 180-day interest rate (annualized):              4.01%-3.97%   

U.S. dollar 180-day interest rate (annualized):    8.01%-7.98%

9.a.   What is the hedged value of American’s ticket sales using a forward market hedge?

9.b.   What is the hedged value of American’s ticket sales using a money market hedge? Assume the first interest rate is the rate at which money can be borrowed and the second one the rate at which it can be lent.

9.c.    Which hedge is less expensive?

Answer 1

American airlines has $ 70 million receivable in 180 days

9a. Hence to do a forward market hedge it will sell $ 70 million dollars at 180 doays forward rate when $/SFr=0.6578/0.6599.

Hence, $ 70 million will be sold at ask rate of 0.6599 getting us 70/0.6599 million swiss francs = SFr 106.0766 million.

9b. To hedge via money market we have to borrow the present value of $ receivable and sell the amount at the current spot rate and invest in SFr at spot investment rate for 180 days.

Present value of $ receivable = Receivable/(1+ borrowing rate)

180 day borrowing rate = (1+annualised borrowing rate)^ ½ -1 =3.9279%

Hence present value == $ 70/(1+0.039279) million =$ 67.3544 million.

The dollar amount will be sold at present spot rate of $ 0.6442/SFr getting us SFr 67.3544/0.6442 million=SFr 104.555 million

The amount will be invested for 180 days, getting us =Investment ( 1+ investment rate)

180 day investment rate = (1+ annualised investment rate)^ ½ -1 =1.9657%

Hence inflow after 180 days= = SFr 104.555(1+0.019657) =SFr 106.6102 million.

9c. As inflow is higher in money market hedging, it is less expensive and should be used.