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Risk Management – Determining which interest rates to use

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Risk Management – Determining which interest rates to use

  • This topic has 1 reply, 2 voices, and was last updated 2 years ago by John Moffat.
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  • Author
    Posts
  • December 1, 2022 at 12:55 pm #673022
    wamunyimaakayombokwa
    Participant
    • Topics: 4
    • Replies: 1
    • ☆

    Good afternoon!

    Please can you kindly help me identify which interest rates to use when hedging against foreign exchange transactions in the money market?

    From my understanding, when hedging against a foreign receivable we borrow money from the foreign country (at the lower rate due to the bank ‘selling’ low) which is divided by the time apportioned ‘borrowing rate’ which is then divided by the spot rate, then multiplied by the time apportioned lower ‘deposit rate’.

    I believe the complete opposite is also true for a payable amount i.e. borrow money from the base country using the time apportioned deposit rate, foreign bank ‘buys’ this currency at the higher rate, which is then divided by the spot rate, and finally multiplied by the borrowing rate.

    My above understanding has proven to work for all of the questions I have attempted so far, however the following example doesn’t follow these rules and gives my a wrong answer, please can you help me understand where I have gone wrong?

    Example:

    Payable by X Ltd (£) to Y Ltd ($) in 3 months: $3,000,000
    Spot rate: 6.170 – 6.210 $ to £
    3 month forward rate: 6.321 – 6.362 $ to £

    $ interest rate: (Borrowing 18%) vs (Deposit 13.5%)
    £ interest rate: (Borrowing 8.1%) vs (Deposit 6.3%)

    Q. What is the cost in £ of a money market hedge?

    Answer:

    £3,000,000 ÷ 1.03375 = $2,902,056
    $2,902056 ÷ 6.170 = £470,349
    £470,349 x 1.02025 = £479,874.

    Thank you very much in advance!!

    December 1, 2022 at 5:08 pm #673061
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54655
    • ☆☆☆☆☆

    I work through examples for both foreign receipts and foreign payments in my free lectures on money market hedging.

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