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Hi sir, I want to ask about market hedge, In most of the book’s practice questions for “import” scenarios, the lower spot exchange rate is used when converting. But in this question, the higher spot rate of $2 = €1 is used instead. Why is the higher rate being used here? What makes this question different from the others?
275. A US company owes a European company €3.5 million, due to be paid in 3 months’ time.
The spot exchange rate is $1.96 – $2.00 : €1. What will be the equivalent US$ value of the payment using a money market hedge?This question is different from others because it involves a payment obligation in euros, requiring the company to convert its dollars to euros. In contrast, in typical import scenarios where the company is converting euros to dollars, the lower buying rate would be used.
If a company is converting foreign currency into its own currency (like in import scenarios), it typically uses the lower buying rate.
This distinction is crucial because it reflects the nature of the transaction: the US company is purchasing euros to pay the European company, hence the use of the higher rate.To calculate the equivalent US dollar value of the payment using a money market hedge, the company would first determine the amount it needs to deposit today to cover the future payment, considering the interest rates in both regions.
The calculation would involve borrowing in the US and investing in Europe to manage the currency risk effectively.
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