- July 16, 2023 at 3:07 pm #688063alawi sayedParticipant
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Hello Mr John,
1 -In a question like the following how do we know that the interest rate given for the local and foreign country are nominal without being mentioned in the question.
2-For the second question asking if the Dollar nominal interest rate is less than the euro nominal interest rate ,DOES THIS SUPPORT THE DIRECTOR’S BELIEF THAT THE EURO WILL DEPRECIATE AGAINST THE DOLLAR?
So by knowing this how the interest rate going to indicate that the Euro will depreciate against the Dollar
I think by looking to the interest rate parity F0=So(1+Ic)/(1+Ib) I think that is showing the effect of this will increase forward exchange rate and hence will depreciate the Euro against dollar.
3- for the same scenario
As regards the interest rate risk faced by Herd Co, which of the following statements is correct?
1- In exchange for a premium, Herd Co could hedge its interest rate risk by buying interest rate options
2- Buying a floor will give Herd Co a hedge against interest rate increases
3- Herd Co can hedge its interest rate risk by buying interest rate futures now in order to sell them at a future date
4- Taking out a variable rate overdraft will allow Herd Co to hedge the interest rate risk through matching.
The answer was 1 which is hedging by interest rate options but why not no 3
which is buying interest rate future and sell them at future date .
Can you please clarify more,
Indicate, by clicking on the relevant boxes in the table below, whether or not each of the following statements support the finance director’s belief that the euro will depreciate against the dollar.
Herd Co is based in a country whose currency is the dollar ($). The company expects to receive €1.5m in six months’ time from Find Co, a foreign customer. The finance director of Herd Co is concerned that the euro (€) may depreciate against the dollar before the foreign customer makes payment and she is looking at hedging the receipt.
Herd Co has in issue loan notes with a total nominal value of $4m which can be redeemed in 10 years’ time.The interest paid on the loan notes is at a variable rate linked to LIBOR. The finance director of Herd Co believes that interest rates may increase in the near future.
The spot exchange rate is €1·543 per $1. The domestic short-term interest rate is 2% per year, while the foreign short-term interest rate is 5% per year.July 17, 2023 at 7:50 am #688242John MoffatKeymaster
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Interest rates quoted are always the actual/nominal rates unless told otherwise (and it is only in discounting questions that real interest rates may be relevant – they have no relevance in this sort of question).
The reason options are a better choice here is that the directors expect that the euro will depreciate against the dollar, so they are not worried about the possibility of the movement being the other way. Futures would be better if they were simply worried that the exchange rate would fluctuate in either direction.
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