Comments

  1. avatar says

    I wanted to ask question but I was even confused on what to ask. By seeing this lecture and I am relating to pilot example.

    Kindly let me know why you have divided the $300 000 / 1.7850, why not to multiply?
    The other thing is that we are recieiving so it should be worst case for us, so why you didn’t take 1.7842?

    This topic of risk management seems to be most tricky, not difficult.

    Many Thanks

    • Profile photo of John Moffat says

      1.7850$’s are equal to 1 £.
      So to convert $300,000 to £’s, we need to divide by 1.7850.
      Think about it – surely if it takes nearly $2 to get 1£, then the equivalent number of pounds must be less that the equivalent number of $’s!

      We are receiving – yes – but if we divided by the lower rate then we would receive more! That cannot be the case :-)

  2. Profile photo of John Moffat 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.

  3. Profile photo of 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 !?

    • Profile photo of John Moffat 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%)

      • Profile photo of 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

  4. avatar says

    Hello John! Trying to understand where the deposit came from! Is it that instead of paying the money early (they had the money in hand) it was deposited to earn an interest? In step (2) was the conversion purely theoretical to ascertain the present value of the deposit converted into pounds and then that amount is borrowed now for 3 mths in pounds. In 3 months the $ deposit matures to 8 m and this is used to pay debt! What about the amount borrowed in pounds?

    • Profile photo of hamzaharoon says

      Sir I Do have the same question which Claudia asked! Please do Explain I also cannot understood why we borrow at step 3 and why we invest at step 1? Do we have Cash in hand at firs? I Understood the Previous question but not this one I am Confused!!!Please Explain :(

      • Profile photo of John Moffat says

        Please ask questions in the F9 Ask the Tutor Forum if you want me to answer – I cannot always read the comments under lectures because there are so many.

        I assume you are asking about example 7.

        The whole idea of money market hedging is to convert money today at todays spot. There is no point in converting money now and paying the supplier immediately because payment is not required until 3 months from now.

        So…..we borrow £’s now, convert now at spot to $’s, and then deposit the $’s for 3 months to earn interest.

        However, there is no point in buying $8M dollars now because in 3 months time it will have earned interest and we will have more than we need.

        So we calculate how many we need to deposit so that it will have grown to $8M in the 3 months.

        Having calculated it we then pay £’s to buy that many $’s.

        Instead of having to pay out £’s now (when otherwise we would not be paying out until 3 months from now) we borrow £’s for 3 months.

        So…..the net cash flow now is zero (we borrow, convert, and deposit). The only real cash flows are in 3 months time – we pay out £’s to repay the borrowing, and the $ deposit matures and pays off the supplier.
        The actual cash flows occur in 3 months time (just as they would have done if we had made a direct payment in 3 months) but it is a fixed amount – what happens to the exchange rate in 3 months is completely irrelevant.

        (Claudia says that the conversion is theoretical – not at all. We borrow, we actually convert, and we deposit.)

  5. avatar says

    In the middle of the Lecture, the person starts discussing a exam question on Money Market Hedge and Forwards, does anyone know where does he get that question from? I couldn’t find it in the relevant class notes.

    Thanks

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