United States Dollar and Money Market Hedge

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Fin6409040

Session7 Chapter 11

11.Forward versus Money Market Hedge on Payables. Assume the following information:

90-day U.S. interest rate = 4%
90-day Malaysian interest rate = 3%
90-day forward rate of Malaysian ringgit = $.400
Spot rate of Malaysian ringgit = $.404

Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit in 90 days. It wishes to hedge this payables position. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated costs for each type of hedge.

ANSWER: If the firm uses the forward hedge, it will pay out 300,000($.400) = $120,000 in 90 days.

If the firm uses a money market hedge, it will invest (300,000/1.03) = 291,262 ringgit now in a Malaysian deposit that will accumulate to 300,000 ringgit in 90 days. This implies that the number of U.S. dollars to be borrowed now is (291,262 × $.404) = $117,670. If this amount is borrowed today, Santa Barbara will need $122,377 to repay the loan in 90 days (calculated as $117,670 × 1.04 = $122,377).

In comparison, the firm will pay out $120,000 in 90 days if it uses the forward hedge and $122,377 if it uses the money market hedge. Therefore, it should use the forward hedge.

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

180-day U.S. 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 a forward hedge or a money market hedge? Substantiate your answer with estimated revenue for each type of hedge.

ANSWER: If the firm uses a forward hedge, it will receive 400,000($1.50) = $600,000 in 180 days.

If the firm uses a money market hedge, it will borrow (400,000/$1.09) = 366,972 pounds, to be converted to U.S. dollars and...
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