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Hi John,
Why are they using the higher rate? its a payment so we are going to buy low right?A US company owes a European company €3.5m due to be paid in 3 months’ time. The spot exchange rate
is $1.96 – $2 : €1 currently. Annual interest rates in the two locations are as follows:
Borrowing DepositUS 8% 3%
Europe 5% 1%
What will be the equivalent US $ value of the payment using a money market hedge?
A $6,965,432
B $6,979,750
C $7,485,149
D $7,122,195Answer
The US company should borrow US$ immediately and send it to Europe. It should be left on deposit
in € for 3 months then used to pay the supplier.
The amount to put on deposit today = €3.5m × 1/(1+ (0.01/4)) = €3,491,272.
This will cost €3,491,272 × $2 = $6,982,544 today (note $2 is the worst rate for buying €)
Assuming this to be borrowed in US$, the liability in 3 months will be:
$6,982,544 × [1+(0.08/4)] = $7,122,195.The exchange rate is quoted as $’s to the €
Since they are buying €’s they will use the higher rate.
(if they were using the lower rate they would be paying less – that cannot be right because it is always the worst rate for us, the bank are the ones who make the profit!)
I don’t understand how they arrived at the money to be deposited today. Isn’t the first step as described in your lectures be to divide the annual interest rate by the hedge duration to found how much to deposit??
5% x 3/12 = 1.25
€3,500,000/1.0125 = €3,456,790?? (now) which is a little less than the original amount of €3,500,000 because we know the interest on deposit will cover the exact principal upon maturity.. €3,456,790 x 1.0125 = 3,500,000.
Hi John,
I have a further clarification to make.If the company is US based and the exchange rate is quoted as
1 $ : € 2 – 2.2
So the company will buy low and sell high?
But if for a US company the exchange rate is quoted as
1 € : $ 2 – 2.2
So it will be opposite and the company will buy high and sell low?
Regards,
Furqan
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