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Hi Mr Moffat.
I have a question on how the answer for the above qn was arrived at by the examiner.
Specifically the qns are a) on how the examiner decided to use (1.00225) and not the spot rate to arrive at the amount of Euros borrowed now?
b)where was the rate of 4% arrived at to decide that the three month rate is 1 %(4%/4)?
These are as per the answers given by the examiner.
Thanks and hope to hear / read on your approach to the qn
A.Ga) the 1.00225 is not an exchange rate! If we are borrowing euros and want to make sure that the receipt from the customer will be enough to repay the borrowing together with interest then we need to borrow a bit less (because interest will be added on).
The interest on borrowing euros is 9% p.a. and so the three month interest will be 9%/4 = 2.25%
So the amount we can afford to borrow now is the amount of the receipt divided by 1.0225 (not 1.00225 – you have typed one too many zeros)b) having converted from euros to $’s, we invest the $’s for 3 months. The question says (2 lines above the requirements) than they can deposit $’s at 4% per year.
(I would suggest that it might be a good idea to watch my lecture on money market hedging)
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