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  4. Dear Sir:

    I have a question. If we are given 2 different interest rates, which are 3-month and 1-year, and we are ask to hedge a payment after 2 months using money market. Which interest rate we should choose?

    I appreciate your suggestion highly

    many thanks

    • In future you must ask this sort of question in the Ask the Tutor Forum and not as a comment on a lecture.

      In most questions you are told that the interest rate is “for up to 3 months” and in that case it is no problem – the 3 month rate applies also to 2 month borrowing.

      If that is not the case than you need to extrapolate using the 3 and 12 months rates in order to estimate a 2 month rate. (And remember that the rates given are always quoted per annum, so the actual interest will be 2/12 of the extrapolated 2 month interest rate.)

  5. Sir,

    I have a struggle on money market hedging. I came across a question that needed the

    receipt to be hedged in 5 months time but the 3-month forward and 1 year forward were

    given including the spot. I understand that we will need to interpolate to get the five month

    forwards and hence it is a straight calculation for forward. The information given for the

    money market hedge consists of interest rates for up to 6 months for the currencies in

    question. My main question is how am i gonna go about the money market hedge?

    Thank you

  7. Dear Sir,

    I was going through your response to tinashe on June 2, 2013 on the money market hedge.

    If someone in the UK needs to deposit dollars to settle a suppliers in the US.

    But again has to borrow GBP to buy the USD for the deposits.

    Are we assuming that he doesn’t have pounds at his disposal to buy dollars for the deposits?

    • No.

      We borrow GBP in order to make the timing the same. If the payment is to be made in (say) three months time, then by borrowing GBP for 3 months it means that the cash flow is not earlier – we still end up with a cash flow in 3 months, but it is of a fixed amount.

      (I do however make clear in the lecture, that in practice you don’t have to borrow – you could pay out the GBP’s immediately. But in the exam we always do for the reason I have written above.)

    • Which example are you asking about, and where are you getting 26,349 from?

      Using the money markets does not cost anything (there are banks charges but we ignore them in the exam and they are not relevant in these two examples). Using the money markets simply fixes the amount payable or receivable on the date of the transaction if we did not do anything then we would be left at risk due to the spot rate changing. If we use the money markets then it is irrelevant what happens to the spot rate – the amount is fixed.

      • i was referring to example 6 – Because at the end of the 3 month period our deposited pounds grow to 3,223,709 which works out to be $4,959,354 at spot rate. This figure is lower than the $5m we are going to receive…. so is the difference of $40,646 dollars the cost of borrowing the initial $4,928,536?

      • But you do not know what the spot rate will be at the end of three months!

        The dollars that we receive go to paying off the dollar loan – we will be owing exactly $5 on the borrowings.
        We keep the GBP the money that we receive on the GBP deposit and so we receive a fixed amount in GBP whatever has happened to the spot rate in 3 months time.

        It doesn’t cost us anything to have fixed the amount that we receive.

  10. Dear sir,
    Your efforts are highly appreciable.
    Sir I am having a confusion. In the receipts case we borrow money for the depositing and later when we get our money we pay off the receipts. I understand
    But in the payment case why are we borrowing money? aren’t we using our money for the deposit. How will I pay our loan if I am not getting any receipts, however we have to do payment in the end.
    Hope u will get my question

      • When we are paying, we borrow money in order to be able to convert into the other currency and then make a deposit.

        After the relevant period, the deposit matures and so we can pay the supplier.
        At the same time we have to pay off the loan.

        So, yes, we make a payment in 3 months time (or whatever the period is) but we would have had to make a payment anyway (because we would have had to pay the supplier). The difference here is that the payment is fixed (because the borrowing was at fixed interest). If we had not done this then the amount of the payment would have been uncertain because the exchange rate may have changed.

      • So here we borrow in our currency and deposit into foreign currency so that we can manage the risk and later we can give that deposited amount to supplier and pay off our loan in our currency ? right ?
        Sir Thank you from the bottom of my heart!

  11. Found its confusing how to choose spot rate when convert the Foreign currency ($) needed to borrow for money market hedging into the local currency(sterling), should I suppose at that point to sell or buy USD, and vise verse when convert deposit foreign current amount into pounds, buy USD or Sell USD?

  12. Dear Tutor,

    I am attempting the practice question and on question 8 which is based on maney market hedge and forward contract, i do not understand why in your answer you did $11600-$197000/1.7063=$546??
    what i did was to take $ 197000 being the receipt and deducted the $116000 before so as to have a net receipt of $81000 and to which i divided by the 1.7063 leaving me with 47471.
    I amhaving another problem with the money market hedge as well as i am taking the net figure.
    Could you or any body help me on this matter?
    thanks

    • I am so sorry – the typing seems to have gone completely mad!
      I will have it corrected immediately.

      With regard to the forward contract, it is a net receipt of $81,000, and it converts to £47471.

      With regard to the money market hedge, the answer should read as follows:

      $81,000 will be the net receipt in three months, so $81,000/(1 + (0.09 x 3/12)) may be borrowed now and converted into sterling, the dollar loan to be repaid from the receipts. The net sterling payment in three months is:
      81,000 / (1+(0.09 x 3/12) ) x 1/1.7140 x (1+(0.095×3/12)) = £47316

      I do apologise. Thank you for spotting it.

      • Hi.
        Thank you for your reply.
        However i do have another concern with that question namely when it says ‘that it is now december with 3 months to the espiry of the march contract ……..’ Can you please clarify this for me and explain how to find out which month to chose for the put option?
        Thanks
        Good job you are doing.i passed 3 papers with your lectures n notes only..;)

      • Also i do not understand the part in your answer where you are comparing the costs, why do you -$297500)

        I did:
        14 contract *£12500*0.0345= $6038 ( premium payable)
        To that i added the cost of 14*12500*1.70= $297500
        Then altogether i added these two numbers and the total was $303538
        Which i the converted at the 1.6967 rate to get £178899..
        Please enlighten me on this issue i really do not understand the answer at the back please explain it.
        Thanks

      • By exercising the options, we are paying out pounds in order to receive dollars (and then use the dollars to pay the supplier).

        So…..we have to pay out GBP 175,000. Then we receive $297500 and use this to pay the $293,000 and the premium of $6038. This leaves us short of $1538 which when converted means paying out an additional GBP 906.

      • The question asks whether options would be better than the forward market or the money market.

        There are several things you could discuss (such as the fact that options benefit from getting the benefit if the exchange rate moves in our favour) but in pure monetary terms the best is the one that involves the lowest cost. So whichever results in the lowest total payment in six months time is the best on this basis.

      • March futures contracts expire at the end of March, which is three months away from December.

        For part (b) we can only deal with the net payment in 6 months time, and therefore we will buy June put options (which are the right to sell June futures). (June is 6 months from now).
        This means that we can only buy options at 1.70 and 1.80 (because 1.60 is not available)

      • Hi again,
        I understand completly what you explained but theres one more thing which is bugging me.
        What is the significance of that £906 to the company? I get it that its an additional costs and then??
        Based on that what is the total cost of hedging by using options?? How do we compare?
        Am really sorry but i do not understand it…

      • The question asks whether options would be better than the forward market or the money market.

        There are several things you could discuss (such as the fact that options benefit from getting the benefit if the exchange rate moves in our favour) but in pure monetary terms the best is the one that involves the lowest cost. So whichever results in the lowest total payment in six months time is the best on this basis.

  13. I’m rather confused on the advantages & disadvantages with regards to forward hedging & money market hedging.

    I can’t see how the amount would change since we already have agreed with the bank on the exchange rates as well as the interest rate, no? Doesn’t it contradict with the certainty of the amount as it is fixed during the arrangement?

    Btw, your lecture is very superb! Love it!

    • But the whole point of using forward rates or using the money markets is to fix the amount that will be payable or receivable.

      If we did nothing, then the exchange rate could end up being anything and we would be at risk – we might pay/receive more or less depending on which way the rate moved. By using forward rates or money markets then the amount is fixed and the risk is removed.

      So I don’t really understand what you mean by your second sentence.

  15. Its clearly explained but the logic illudes me, what then do i do with the borrowed pounds?
    I understood i deposits the US$7.8m so i make us$8m to use to pay my creditors with in 3months time.

    Unless the logic is that since iam in the UK, and i owe someone in the USA 8m, and iam worried in three months time, whilst the rate today of pounds to US$ favours me, like say, if i had to settle the debt today i would say pay equivalent in pounds 6m, however its highly likely in three months time the pound equivalent of the same debt will be 7m pounds . Hence i take the 6m pounds today and convert them to 7.8m us dollars and deposit in a dollar denominated account so in three months time i dont have to suffer any convertion losses. That maybe i would understand however this logic explained above iam getting confused John.

    why am i borrowing the pounds???

    • You understood that we want to deposit dollars today.
      So we need to buy dollars today, but that means having to pay out pounds (to be able to buy the dollars).
      So….we need to borrow pounds for 3 months.

      If we did nothing to hedge the risk, then the only cash flow would be that we would pay out pounds in 3 months, but we would be at risk because of the exchange rate changing.

      Here, we are still paying out pounds in three months (and the dollar deposit pays the supplier), but it is a fixed amount – it does not matter what happens to the exchange rate.
      We are not trying to make a profit out of the exercise – the object is to remove the risk.

      • Dear instructor,

        Since most of the comments are in 2011, this discussion thread may be closed but I am trying my luck anyway. If we knowthe WACC of a company, can we use that rate to determine the future value of the amount borrowed, and use this future value to compare against the other hedging strategies?

        Thank you!

      • The comments on the lectures are never closed – it is only in the Ask the Tutor forums that discussions are sometimes closed when dealt with. (And I am puzzled why you write that most of the comments are in 2011 🙂 )

        To answer your question, there would be no logic in using the WACC. The borrowing and depositing is done at fixed interest – whatever rates that the money markets are offering at the time – and the purpose is to effectively fix an exchange rate at the date of the transaction. When comparing with other strategies it is simply a question of comparing the fixed amounts on the date of the transaction.

      • Thank you for your response – I glanced quickly through the comments and saw many were in 2011 hence my comment. I should have noticed the ones dated 2012 and 2013 :).

        I found your explanation very clear and your lecture to be very helpful. However, I don’t think I phrased my question correctly – the reason why I asked about WACC is because the time value of money can also be calculated at the cost of capital (WACC). The logic of this is that the company trying to decide on the best hedging strategy, can choose to invest funds at least to earn cost of capital. So, they assume that they should be able to earn at least the WACC rate per annum on their investment.

        Of course this may not be a fair comparison against another hedging strategy like a forward hedge which takes into account a risk free rate of return so we do need to make that distinction.

        I am asking is because in my corporate finance course, one of the home questions had used the WACC to calculate the future value of borrowed amount in a money market hedge for comparison against other hedging strategies.

        Thank you!

      • I understand your point, but although normally the company will wish to earn at least the WACC, in this situation they are borrowing and investing purely in order to ‘fix’ the effective exchange rate on the future date. To do this they have to have fixed interest rates, which they can only get using the money markets and accepting whatever rates are applicable there.

      • With regard to using a forward contract, in the real world the forward rate offered by the bank is actually calculated by them using the money market interest rates (not risk free rates). In real life (ignoring the banks commissions/charges) using the money markets and using a forward rate would end up giving exactly the same end result.

      • Yes, you are right. In the examples you had used in your lecture, the main point is to obtain the “fixed” exchange rate.

        I guess my corporate finance textbook and homework are just using the WACC as an alternative example to calculate the future value of amount borrowed if we do not have fixed interest rates information.

    • Example 7 states that we have to pay $8m in 3 months. We want to eliminate the foreign exchange risk by using money market hedging. First of all, we have to borrow GBP 4,860,203.Then use GBP to buy $7,874,016 (at 1.6201). Finally, we deposit $7,874,016 at 6.4% p.a. We make $125,984 of interest on the deposit, so in 3 months we will receive exactly $8m, which we can use to settle our obligation. Also, in 3 months time we repay GBP 4,980,493 (including interest).

  17. Amazingly simple explanation that is so easily digestable. Thanks to the tuitor’s exerience and very logical and easy to follow explanations.
    many thanks!

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