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johnmoffat says

No we didn’t have the $’s already. If we already had them then there would be no point in any of it!!!

We need to buy $’s. If we want we can simply wait 3 months and buy them, but there is then the risk of the exchange rate having changed.

To avoid it we buy the $’s now at todays exchange rate.

How can we afford to buy them? We borrow £’s now so that we can afford to buy the $’s.

Now we have the $’s, but there is no point in paying the supplier immediately. So….we put them on deposit and pay him in three months.

Sam says

now it’s all clear, cause if you looked at comments by claudia1 and hamzaharoon, they also thought that company has the $’s already and that what confused me.

anyway, thank you very much indeed for your help

Regards

johnmoffat says

You are welcome

Sam says

Hi Mr John,

Sorry for asking about the same point that claudia1 and Hamzaharoon did ask about before

but what I understood from your lecture and your answer to their question is that:

yes we’re actually depositing and converting, but the whole idea of borrowing is to use this money for other investment purposes and not lose the chance of using the money deposited to pay out the supplier’s debt!, do you get what mean !?

Again, In example 7 question, why is it mentioned that “current 3 month interest rates” if the rates are yearly! or is it just to trick us !?

johnmoffat says

I am not sure I understand what you mean. If there were other investments and we needed money, we could always borrow the money anyway.

The whole point of borrowing and depositing is so that the eventual cash flow ends up at the same time as it would if we didn’t do any hedging at all, or if we used forward rates.

We can then compare the eventual cash flow for money markets with the eventual cash flow if we used forward rates,

With regard to ’3 month interest rates’. Interest rates are always quote in the exam as yearly interest rates. However, the bank will offer (or charge) different yearly rates depends on how long the deposit (or borrowing) is for. For example, if you are borrowing for 3 months they might charge at the rate of 10% p.a., but if you were borrowing for 6 months they might charge 12% p.a.. This is what happens in real life.

(However, they will only actually charge it for 3 months or for 6 months. So if you are borrowing for 3 months and they are charging 10% p.a., the actual interest charged will be 3/12 x 10%)

Sam says

the main point that confuses me is that in example 7, we are:

1_ depositing (this means we have the $’s already and we have deposited them for 3 months)

2_ Converting: to see how many £’s are they.

3_ Borrowing: which I couldn’t get the point of it as we have the money already and they are deposited so why would we be bothered to borrow more money and pay extra cost of interest when we have the $’s in the first place !!

if the sequence were like example 6 (Borrowing, converting and depositing) then there would be no problem in terms of “justifying the purpose of each step”. while “depositing, converting-which takes place now- and then borrowing” didn’t get through and it seemed to me pointless to borrow more money!

with regards to the “three months rate” it is now clear.

many thanks Mr John

Regards

Sam