Question

A European company is importing (purchasing) $600,000 of goods in one year. The current spot price is $1.23/€. Risk free rates in the US and Eurozone are 4% and 3%, respectively. The forward rate is $1.20/€. Your CEO wants to implement a money market hedge. This involves borrowing in one currency to purchase the other currency (which you will then invest for one year). What is the amount you are borrowing? Once the money market hedge is finalized a year later, was this hedge more favorable than a forward hedge?

Answer 1

US Interest Rate = 4 % and Euro Interest Rate = 3 %, Payable = $ 600000 and Tenure = 1year

Current Spot Rate = $ 1.23 / €.

A money-market hedge can be implemented as described below:

- Borrow the € equivalent amount of the present value of $ payable. PV of Payable = 600000 / 1.04 = $ 576923.0769

- Convert this $ present value into € at the current spot rate to yield = 576923.0769 / 1.23 = € 469043.152 in € borrowings

- This € borrowing creates a €. payable worth = 469043.152 x 1.03 = € 483114.446.

- Convert this € borrowing into $ and invest the same at the US Interest Rate to yield $ 600000 which can be paid for the import. The original € borrowing needs to be paid off by making a repayment worth € 483114.446

- Therefore, € 483114.152 = $ 600000. Money-Market Hedge Exchange Rate = 600000 / 483114.152 = $ 1.242 / €

Forward Rate = $ 1.2 / €

As the money-market hedge buys more $ per € as compared to the forward rate, the former (money-market hedge) is more favorable to the latter (forward hedge).