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Dear Sir,
I have a doubt with this question
A US company owes a European company €3.5 due to be paid in 3 months time.
The spot exchange rate is $1.96-$2 : €1 currently. Annual interest rates in two locations are as follows:
Borrowing Deposit
US 8% 3%
Europe 5% 1%What will be the equivalent US $ value of the payment using a money market hedge?
My question is if its a payable shouldn’t we use the $1.96 spot rate when we borrow the money? This question was from BPP exam kit and the answer used the worst spot rate of $2.
I hope you can clarify this. Thank you!
They should certainly use the ‘worst’ rate!
They need to borrow enough dollars to be able to pay in euros. The difference between the two exchange rates is the banks profit – the company therefore is forced to use whatever is ‘worst’ for them. Converting at $2 per euro will cost more than converting at $1.96 per euro, and therefore $2 is the rate to use.
I do suggest that you watch my free lectures on foreign exchange risk management. The first lecture does spend time explaining which rate to use, and when 🙂
Sir, I have another question regarding forward exchange rate.
Question:
The current spot rate for the US dollar/euro is $/€ 2.0000 +/- 0.003. The dollar is quoted at a 0.2c premium for the forward rate.
What will a $2000 receipt to be translated to at the forward rate?Answer:
The spot rate for translating $ to € is 2.0000 + 0.003 = $2.003 / € – the worst rate for someone selling dollars. The dollar is at a premium so subtract the premium because the exchange rate is to the Euro so if the $ is strengthening then the Euro is weakening on the forward market.Could you explain further as to why we subtract the premium of 0.2c? From my understanding, we subtract the premium because we are using today’s rate so, minus off the premium to get today’s rate. Correct me if I’m wrong!
Thank you.
Forgetting the spread, the exchange rate is that 1 euro will buy 2 dollars.
If the dollar is strengthening then 1 euro will buy less than 2 dollars. So we subtract the premium.
Please do watch my free lectures on foreign exchange risk management because I do explain this point 🙂
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