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A US company owes a European company EUR3.5 million due to be paid in 3 months’ time. The spot exchange rate is $1.96 – $2 : 1 currently. Annual interest rates in the 2 locations are as follows:
US Borrow – 8% deposit 3%
Europe Borrow – 5% deposit 1%.What will be the equivalent US $ value of the payment using a money market hedge?
A = 6.965,432
B= 6,979,750
C= 7,485,149
D= 7,122,195The answer is D and is calculated as follows:
Amount to be deposited today = 3.5 million EUR x 1(1+(.01/4))=3419272
The cost 3491272 x 2 = 6982544 today.
Assuming this to be borrowed in US$ the liability in 3 months will be 6,982,544 x (1+(.08/4))=7,122,195.XXXX
The answer here uses higher rate 2, my question is aren’t we supposed to use lower rate i.e. 1.96 when converting it to dollars since we are buying from bank ( bank sells at low )
You must watch the free lectures on foreign exchange risk management because before dealing with the different methods available to reduce the risk, I work through several examples explaining which of the two rates to use when exchanging money – I cannot possibly type out all of the lectures here 🙂
The exchange rate is quoted as $’s to the Euro, and therefore since the company is selling $’s to buy Euros, the conversion is at the higher rate. (If the conversion were at the lower rate it would cost the company less, which could not possibly be the case – it is the bank who make the profit! 🙂 )
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