- This topic has 7 replies, 3 voices, and was last updated 10 years ago by
.
- Posts
Hello,
I am still not understanding the logic behind Step 3 of the process? What I understand from the principle is that, a payment is to be made, so we create an asset via a deposit. When the deposit matures, we use that money to make the payment in 3 months time.
So why is the borrowing necessary? It seems that the company would be in a “lose-lose” situation as they would have to pay the supplier and repay the borrowing.
I was thinking that the company could just change the money into sufficient foreign currency now and place it on deposit so that it will earn interest to become the required amount at the appropriate point in time. Is that what we would have done in working out the problem? I am not really seeing the application of this principle.
Could you please shed some light on this?Regards,
The could certainly have done what you suggest (and if you have listened to my free lecture you will have heard me say that).
However doing what you suggest would mean them paying out cash now, whereas if they had not bothered about hedging at all then they would not be paying out cash until 3 months from now.
So….instead of having to pay out cash now, they borrow money for 3 months and only have to pay out cash in 3 months time to repay the borrowing.
In that way they still only pay out cash in three months, but the amount that they will pay is fixed (as opposed to being uncertain if they had done nothing and had to simply convert at the spot in 3 months).
They are not in a lose-lose situation. As of now there is no net cash flow – they borrow money, convert it, and deposit it. No net cash flow.
In three months time, they have to repay the deposit. At the same time the deposit matures and that money goes to the supplier.YES SIR…
BUT BORROWING COST THEM INTEREST, IF HE USES HIS CASH IN HAND, IT WILL BE CHEAPER FOR HIM, INSTEAD OF BORROWING…HE CONVERTS HIS CASH, DEPOSITS IN BANK, AFTER 3 MONTHS GET INTEREST ON MATURITY AND PAY IT…
WHY BORROWING IS MUST????
(Please do not write in capitals!)
Who said borrowing is a must? I certainly did not!
If you read my reply above, and if you have listened to my free lecture, then in both places I said that they could pay the money now and not bother borrowing.
However, that would mean they were paying money out now which is earlier than they would have to otherwise. (And paying the money now would still cost them interest – even if they have the cash available, they would lose interest that they could have earned on it).
More importantly, in the exam you are almost always asked to hedge using forward rates, hedge using money markets, and then compare.
Since using forward markets automatically would mean paying out the money in three months time, you then have to do all the steps in money market hedging (including borrowing) so that you would be paying out money that way in 3 months time as well.Then you can say which one is cheaper in three months time.
(you could not compare paying out in 3 months with forward rates, with paying out immediately with money markets).Finally (although more than is asked in the exam) the real importance is that the way the banks quote forward rates is as follows:
There will be lots of people who want forward rates, and the bank effectively puts all their money together and does money market hedging with it. Because of fixed interest rates they know what the end result will be and they use this to fix the forward rates that they offer. The forward rates are not simply a guess from the banks – they are determined by the relative interest rates in the two countries.
- You must be logged in to reply to this topic.