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Hi
Question:
P is due to receive $5M in 3 months time.
Spot: $/£ 1.5384 – 1.5426
Current 3 month interest rates: US prime 5.2% – 5.8% UK LIBOR 3.6% – 3.9%
Show how P can use the money markets to hedge the risk.Answer:
Borrow $’s —————— 5M ÷ 1.0145 = $4,928,536
Convert at spot ———- 4,928,536 ÷ 1.5426 = £3,194,954
Invest £’s ——————- 3,194,954 × 1.009 = £3,223,709I get how it’s done. My doubts
1. We converted $4,928,536 and not 5M. Is this because $4,928,536 is effectively the present value of 5M in three months?
2. How is the sale treated in the books? Sale of £3,194,954?
3. The given interest rates are “3 month interest rates”. Why did we need to multiply 3/12 when it’s already given for 3 months? In the lecture, you said it’s the annual rate.1. Yes – it is put on deposit and when interest has been added it will have grown to $5M
2. How it is recorded in the books is of no relevant to Paper FM. Given that they are due to receive $5M then this is the sale that will have been recorded.
3. Yes, it is an annual rate. But since we are only getting interest for 3 months then the actual interest we will receive or pay is 3/12 of the annual rate.
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