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Hi John,
Can you pls help me with the q below – BPP q 92.5 revision kit
A US company owes a European company €3,5m due to be paid in 3 maths. The spot exchange rate is $1.96:€1 currently. Annual interest rates:
Borrowing Deposit
US 8%. 3%
Europe 5%. 1%
What will be the equivalent US $ value of the payment using a money market hedge?
The answer in the kit is very confusing for me:
The US company should borrow US$ immediately and send it to Europe. It should be left on deposit in € for 3 mths then used to pay the supplier. The amount to put on deposit today =€ 3.5m x 1/(1+(0.01/4))=€3,491,272
This will cost €3,491,272x$2=$6,982,544 today. Assuming this to be borrowed in US$, the liability in 3 mths will be $6,983,544 x (1+(0.08/4))=$7,122,195
So it starts of by saying they should borrow and put on the deposit where as the calculation is done the other way around?
Would really appreciate your help.
Thank you in advance.
Regards,
AgnesThe answer is correct but it is difficult to explain here without going through an entire lecture on money market hedging.
You really need to watch the free lecture on this.
(We have to do the calculation the other way round because until we know how much we need to deposit, we don’t know how much we need to convert and therefore how much we need to borrow.)
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