Question

Assume the following information

180 day US interest rate = 8%
180 day British interest rate = 9%
180 day forward rate of British pound = 1.50
Spot rate of British pound = 1.48

Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180 days. Would it be better off using forward hedge or a money market hedge? Substantiate your answer with estimated revenue for each type of hedge and show all work.

Answer 1

the 180 day forward hedge rate is = $1.5 /pound

now, that the US firm will recieve 4,00,000 pounds.

at the forward hedge, the firm will receive upon conversion = $6,00,000

the calculation in the money market hedge can also be computed as below,

since the US firm is going to receive 400,000 pounds in 180 days it wants to hedge, so that the value doesnt fall after 180 days the firm will borrow 4,00,000 pounds at the current rate offered i.e 9% in the british markets.

MONEY MARKET HEDGE ON RECEIVBALE:

the U.S firm will borrow (4,00,000/1.09) =366,972 pound at the current interest rate of 9% to be converted to US dollars and invested in the U.S. The loan will be repaid by the inlux of 4,00,000 pounds in 180 days. the borrowing of the pound today will offset the transaction exposure due to the future receivables in pounds.

now, 366,972 pounds will be converted to US dollars at the spot $1.48 exchange/pound rate,to receive $543118 which when invested at 8% will give a total return of $5,86,569.

the revenue earned on the future's contract will be : $6,00,000

the revenue earned on the market hedge will be : $5,86,569.