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Hello Sir,
From your great explanation I could understand the concept of the interest hedging
But the there is one thing which I don’t know why
Why for for selecting the borrowing rate for the foreign currency we take the foreign country rate not the home country rate although we are in the home country. what is the logic behand that?
like in the following example from kaplan 2022-2023 exam kit :
A company whose home currency is the dollar ($) expects to receive 500,000 pesos in six
months’ time from a customer in a foreign country. The following interest rates and exchange
rates are available to the company:
Spot rate 15.00 pesos = $1
Six?month forward rate 15.30 peso = $1
Home country
Foreign country
Borrowing interest rate
4% per year
8% per year
Deposit interest rate
3% per year
6% per yearWorking to the nearest $100, what is the six?month dollar value of the expected receipt
using a money?market hedge?A
$32,500
B
$33,700
C
$31,800
D
$31,900The answer is A
Thanks sir.
They are going to receive prose in 6 months time. So with money market hedging they will borrow pesos now (so they can repay the borrowing later when they receive the pesos) and will convert the pesos they borrow now into $’s (and invest the dollars). Given that 15 pesos equals 1 $ now, they will divide by 15 to convert to $’s.
Hello Sir,
My question was for the first step in the solution (borrowing) that we have to divide 500,000 pesos by borrowing interest rate (4%/2) of the foreign country.
In order to borrow now why we have to use the foreign country and not the home country interest rate even though we are in the home countrywhy is that ?
Thanks,
We are borrowing pesos, and it is irrelevant where we actually borrow them. The interest rate is the interest rate for pesos.
(You can borrow (and invest) in any currency in any country).
Have you not watched my free lectures on this? The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
Hello Sir,
So if we use the home borrowing interest rate for 500000 pesos it will be okay and does that affect the solution?
because in the lecture you used the foreign interest rate.Thanks,
No it won’t be OK.
If you borrow Peso’s you use the Peso interest rate – it doesn’t matter in which country you actually do the borrowing.
If (for example) you live in the UK then you can borrow or invest money in lots of different currencies. The rate of interest depends on which currency – not on where you live.
Hello Sir,
Because in question we are giving two rates in home country and one foreign country so if I want to borrow pesos I should use the foreign currency because it gives how much the interest for pesos
but If I use the home currency does it mean that the reverse interest rate for i.e $ ?
This is what I want to differentiate that the home interest rate will not give me the rate of interest for pesos but may be as I think for dollars ?
am I correct ?
Thanks
No, they will be borrowing pesos and will pay the peso interest rate.
Then they will convert the pesos to $’s using the current exchange rate.
Then they will invest the $’s using the $ interest rate.
Have you not watched my free lectures on this? I explain money market hedging in detail, with examples.
Hello,
I understood the process of the hedging from your lectures but still I don’t see any use of the home country -borrowing interest rate it has not been used at all in the solution.
Thanks,
It is not used because they are not borrowing any $’s – they are borrowing pesos.
The are investing the $’s and so will use the $ deposit rate to determine how many $’s are available at the end of 6 months.
Yes Thank you Sir,
This is what I want to know .even if you check my chatting with you will see that I recommended the same .
Thanks a lot.
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