Comments

  1. avatar says

    Found its confusing how to choose spot rate when convert the Foreign currency ($) needed to borrow for money market hedging into the local currency(sterling), should I suppose at that point to sell or buy USD, and vise verse when convert deposit foreign current amount into pounds, buy USD or Sell USD?

  2. avatar says

    Dear Tutor,

    I am attempting the practice question and on question 8 which is based on maney market hedge and forward contract, i do not understand why in your answer you did $11600-$197000/1.7063=$546??
    what i did was to take $ 197000 being the receipt and deducted the $116000 before so as to have a net receipt of $81000 and to which i divided by the 1.7063 leaving me with 47471.
    I amhaving another problem with the money market hedge as well as i am taking the net figure.
    Could you or any body help me on this matter?
    thanks

    • Avatar of johnmoffat says

      I am so sorry – the typing seems to have gone completely mad!
      I will have it corrected immediately.

      With regard to the forward contract, it is a net receipt of $81,000, and it converts to £47471.

      With regard to the money market hedge, the answer should read as follows:

      $81,000 will be the net receipt in three months, so $81,000/(1 + (0.09 x 3/12)) may be borrowed now and converted into sterling, the dollar loan to be repaid from the receipts. The net sterling payment in three months is:
      81,000 / (1+(0.09 x 3/12) ) x 1/1.7140 x (1+(0.095×3/12)) = £47316

      I do apologise. Thank you for spotting it.

      • avatar says

        Hi.
        Thank you for your reply.
        However i do have another concern with that question namely when it says ‘that it is now december with 3 months to the espiry of the march contract ……..’ Can you please clarify this for me and explain how to find out which month to chose for the put option?
        Thanks
        Good job you are doing.i passed 3 papers with your lectures n notes only..;)

      • avatar says

        Also i do not understand the part in your answer where you are comparing the costs, why do you -$297500)

        I did:
        14 contract *£12500*0.0345= $6038 ( premium payable)
        To that i added the cost of 14*12500*1.70= $297500
        Then altogether i added these two numbers and the total was $303538
        Which i the converted at the 1.6967 rate to get £178899..
        Please enlighten me on this issue i really do not understand the answer at the back please explain it.
        Thanks

      • Avatar of johnmoffat says

        By exercising the options, we are paying out pounds in order to receive dollars (and then use the dollars to pay the supplier).

        So…..we have to pay out GBP 175,000. Then we receive $297500 and use this to pay the $293,000 and the premium of $6038. This leaves us short of $1538 which when converted means paying out an additional GBP 906.

      • Avatar of johnmoffat says

        The question asks whether options would be better than the forward market or the money market.

        There are several things you could discuss (such as the fact that options benefit from getting the benefit if the exchange rate moves in our favour) but in pure monetary terms the best is the one that involves the lowest cost. So whichever results in the lowest total payment in six months time is the best on this basis.

      • Avatar of johnmoffat says

        March futures contracts expire at the end of March, which is three months away from December.

        For part (b) we can only deal with the net payment in 6 months time, and therefore we will buy June put options (which are the right to sell June futures). (June is 6 months from now).
        This means that we can only buy options at 1.70 and 1.80 (because 1.60 is not available)

      • avatar says

        Hi again,
        I understand completly what you explained but theres one more thing which is bugging me.
        What is the significance of that £906 to the company? I get it that its an additional costs and then??
        Based on that what is the total cost of hedging by using options?? How do we compare?
        Am really sorry but i do not understand it…

      • Avatar of johnmoffat says

        The question asks whether options would be better than the forward market or the money market.

        There are several things you could discuss (such as the fact that options benefit from getting the benefit if the exchange rate moves in our favour) but in pure monetary terms the best is the one that involves the lowest cost. So whichever results in the lowest total payment in six months time is the best on this basis.

  3. avatar says

    I’m rather confused on the advantages & disadvantages with regards to forward hedging & money market hedging.

    I can’t see how the amount would change since we already have agreed with the bank on the exchange rates as well as the interest rate, no? Doesn’t it contradict with the certainty of the amount as it is fixed during the arrangement?

    Btw, your lecture is very superb! Love it!

    • Avatar of johnmoffat says

      But the whole point of using forward rates or using the money markets is to fix the amount that will be payable or receivable.

      If we did nothing, then the exchange rate could end up being anything and we would be at risk – we might pay/receive more or less depending on which way the rate moved. By using forward rates or money markets then the amount is fixed and the risk is removed.

      So I don’t really understand what you mean by your second sentence.

  4. avatar says

    Its clearly explained but the logic illudes me, what then do i do with the borrowed pounds?
    I understood i deposits the US$7.8m so i make us$8m to use to pay my creditors with in 3months time.

    Unless the logic is that since iam in the UK, and i owe someone in the USA 8m, and iam worried in three months time, whilst the rate today of pounds to US$ favours me, like say, if i had to settle the debt today i would say pay equivalent in pounds 6m, however its highly likely in three months time the pound equivalent of the same debt will be 7m pounds . Hence i take the 6m pounds today and convert them to 7.8m us dollars and deposit in a dollar denominated account so in three months time i dont have to suffer any convertion losses. That maybe i would understand however this logic explained above iam getting confused John.

    why am i borrowing the pounds???

    • Avatar of johnmoffat says

      You understood that we want to deposit dollars today.
      So we need to buy dollars today, but that means having to pay out pounds (to be able to buy the dollars).
      So….we need to borrow pounds for 3 months.

      If we did nothing to hedge the risk, then the only cash flow would be that we would pay out pounds in 3 months, but we would be at risk because of the exchange rate changing.

      Here, we are still paying out pounds in three months (and the dollar deposit pays the supplier), but it is a fixed amount – it does not matter what happens to the exchange rate.
      We are not trying to make a profit out of the exercise – the object is to remove the risk.

      • avatar says

        Dear instructor,

        Since most of the comments are in 2011, this discussion thread may be closed but I am trying my luck anyway. If we knowthe WACC of a company, can we use that rate to determine the future value of the amount borrowed, and use this future value to compare against the other hedging strategies?

        Thank you!

      • Avatar of johnmoffat says

        The comments on the lectures are never closed – it is only in the Ask the Tutor forums that discussions are sometimes closed when dealt with. (And I am puzzled why you write that most of the comments are in 2011 :-) )

        To answer your question, there would be no logic in using the WACC. The borrowing and depositing is done at fixed interest – whatever rates that the money markets are offering at the time – and the purpose is to effectively fix an exchange rate at the date of the transaction. When comparing with other strategies it is simply a question of comparing the fixed amounts on the date of the transaction.

      • avatar says

        Thank you for your response – I glanced quickly through the comments and saw many were in 2011 hence my comment. I should have noticed the ones dated 2012 and 2013 :).

        I found your explanation very clear and your lecture to be very helpful. However, I don’t think I phrased my question correctly – the reason why I asked about WACC is because the time value of money can also be calculated at the cost of capital (WACC). The logic of this is that the company trying to decide on the best hedging strategy, can choose to invest funds at least to earn cost of capital. So, they assume that they should be able to earn at least the WACC rate per annum on their investment.

        Of course this may not be a fair comparison against another hedging strategy like a forward hedge which takes into account a risk free rate of return so we do need to make that distinction.

        I am asking is because in my corporate finance course, one of the home questions had used the WACC to calculate the future value of borrowed amount in a money market hedge for comparison against other hedging strategies.

        Thank you!

      • Avatar of johnmoffat says

        I understand your point, but although normally the company will wish to earn at least the WACC, in this situation they are borrowing and investing purely in order to ‘fix’ the effective exchange rate on the future date. To do this they have to have fixed interest rates, which they can only get using the money markets and accepting whatever rates are applicable there.

      • Avatar of johnmoffat says

        With regard to using a forward contract, in the real world the forward rate offered by the bank is actually calculated by them using the money market interest rates (not risk free rates). In real life (ignoring the banks commissions/charges) using the money markets and using a forward rate would end up giving exactly the same end result.

      • avatar says

        Yes, you are right. In the examples you had used in your lecture, the main point is to obtain the “fixed” exchange rate.

        I guess my corporate finance textbook and homework are just using the WACC as an alternative example to calculate the future value of amount borrowed if we do not have fixed interest rates information.

    • avatar says

      Example 7 states that we have to pay $8m in 3 months. We want to eliminate the foreign exchange risk by using money market hedging. First of all, we have to borrow GBP 4,860,203.Then use GBP to buy $7,874,016 (at 1.6201). Finally, we deposit $7,874,016 at 6.4% p.a. We make $125,984 of interest on the deposit, so in 3 months we will receive exactly $8m, which we can use to settle our obligation. Also, in 3 months time we repay GBP 4,980,493 (including interest).

  5. avatar says

    dear tutor, i’m trying to get the lecture on money market hedging but it’s not coming up!
    also the forward contract did not finish…just played 8minutes!

    thanx for huge help

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