Money market hedge

Contents Problem-1: Foreign currency receipt ........................................................................................................................3 Problem-2: Foreign currency payment .....................................................................................................................6

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Money market hedge

Those who consume interest cannot stand (on the Day of Resurrection) except as one stands who is being beaten by Satan into insanity. That is because they say, Trade is (just) like interest. But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah. But whoever returns to (dealing in interest or usury) - those are the companions of the Fire; they will abide eternally therein. (Surat Al-Baqarah: 275)

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Money market hedge Problem-1: Foreign currency receipt

Nedwen Co is a UK-based company expected to receive $300,000 in three months time. The finance manager has collected the following information: Per 1 Sport rate $1.7820 + 0.0002 This represents spread. That means if Nedwen buy $ now (i.e. at spot), the exchange rate will be 1 = $1.7818 ($1.7820 0.0002). If Nedwen sell $ now, the exchange rate will be 1 = $1.7822 ($1.7820 + 0.0002). Golden rule! - Favorable rate is always for the bank. Borrowing One year interest rate One year $ interest rate 4.9% 5.4% Deposit 4.6% 5.1%

Money market rates for Nedwen Co:

Assume that it is now 01 April.

Situation: Nedwen is a UK company. So, its currency is (British Pound Sterling). Nedwen will receive $300,000 (foreign currency) in three months time. So, after receiving $300,000 in three months time, Nedwen expected to sell $300,000 to buy . Receivable $300,000 01 April 30 June Foreign currency

Risk: will get stronger or $ will get weaker. The exact amount to be received in home currency () is not known, and that can be lower than expected. Risk 1 = $1.7822 01 April

1 = $?? 30 June

or $

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Money market hedge

Money market hedge: Step-1: Determine the amount of $ to be borrowed now which will be $300,000 in 3 months time with interest. After 3 months when Nedwen will receive $300,000, Nedwen will use this $300,000 receipt to pay back the above $300,000 liability. 3 months $ borrowing rate: 5.4% X 3/12 = 1.35% = 0.0135. So, amount of $ to be borrowed now: $300,000/(1+0.0135) = $296,004. After 3 months, this amount will be $300,000 with interest ($296,004 X (1+0.0135) = $300,000). Nedwen will pay off this liability with the $300,000 it will receive in 3 months time.

Borrow: $296,004 3 months $ borrowing rate: 1.35% 01 April

Liability with interest: $300,000 30 June

Repayment by $300,000 receipt in 3 months time

But, what Nedwen will do with the $296,004 it is borrowing now!? Nedwen will sell this $296,004 now (i.e. at spot) to buy (home currency).

Step-2: Buy by selling $ at spot (now). $296,004/1.7822 = 166,089 Borrow: $296,004 01 April Buy : 166,089 Now, assume Nedwen has nothing to do with this 166,089. So, decided to make short-term three month deposit. 30 June

Step-3: Deposit for 3 months. 3 months deposit rate: 4.6% X 3 /12 = 1.15% = 0.0115 At end of 3 months the amount of will be with interest: 166,089 X (1 + 0.0115) = 167,999.

3 months deposit rate: 1.15% 01 April Deposit: 166,089 30 June Deposit with interest: 167,999

So, for the $300,000 to be received in 3 months time, Nedwen will get 167,999 if it does money market hedge. Effective exchange rate will be: 1 = $1.7857 ($300,000/ 167,999)

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Money market hedge

Money market hedge: Foreign currency receipt

Borrow: $296,004 3 months $ borrowing rate: 1.35% 01 April Buy : 166,089 Deposit: 166,089 3 months deposit rate: 1.15%

Liability with interest: $300,000 30 June Deposit with interest: 167,999

Repayment by $300,000 receipt in 3 months time

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Money market hedge Problem-2: Foreign currency payment

ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso interest rates were relatively cheap compared to dollar interest rates. Economic difficulties have now increased peso interest rates while dollar interest rates relatively stable. ZPS Co must pay interest of 5,000,000 pesos in six months time. The following information is available. Per $ Spot rate Interest rates that can be used by ZPS Co: Borrow Peso interest rates Dollar interest rates 10.0% per year 4.5% per year Deposit 7.5% per year 3.5% per year 12.500 pesos 12.582 pesos

Situation: ZPSs home currency is $, and peso is the foreign currency. ZPS will have to pay 5,000,000 pesos (foreign currency) in six months time. So, to pay 5,000,000 pesos in six months time, ZPS will need to sell $ to buy 5,000,000 pesos. Payable 5,000,000 pesos Month 0 Month 6 Foreign currency

Risk: Peso will get stronger or $ will get weaker. In six months time the exact amount to be paid in home currency ($) is not known. The cost can be higher than expected. Risk $1 = 12.500 Pesos Month 0

$1 = Pesos?? Month 6

Peso

or $

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Money market hedge

Money market hedge: Step-1: Determine the amount of pesos to be deposited now which will be 5,000,000 pesos in 6 months time with interest Six months peso deposit interest rate: 7.5% X 6/12 = 3.75% = 0.0375 So, amount of pesos to be deposited now: (5,000,000/ (1+0.0375)) = 4,819,277.11 pesos. In six months time 4,819,277.11 pesos deposit will be (4,819,277.11 X (1 + 0.0375)) = 5,000,000 pesos with interest. ZPS will pay off the liability from this deposit.

Deposit: 4,819,277.11 pesos 6 months peso deposit rate: 3.75% Month 0

Deposit with interest: 5,000,000 pesos Month 6

Payment to settle 5,000,000 pesos liability

But, where ZPS will get 4,819.277.11 pesos to deposit now!? ZPS will need to buy 4,819.277.11 pesos now (i.e. at spot) by selling $ (home currency).

Step-2: Buy pesos by selling $ at spot (now). 4,819.277.11 pesos/ 12.500 = $385,542.17 Sell $: $385,542.17 Month 0 Buy pesos: 4,819.277.11 pesos Month 6

But, where ZPS will get $385,542.17 to sell now!? ZPS will need to borrow this $ for six months.

Step-3: Borrow $ for six months. 6 months $ borrowing rate: 4.5% X 6 /12 = 2.25% = 0.0225 At end of 6 months the $ liability will be with interest: $385,542.17 X (1 + 0.0225) = $394,216.87. ZPS will pay off the $394,216.87 liability by its own cash.

6 months $ borrowing rate: 2.25% Month 0 Borrow: $385,542.17 Month 6 Liability with interest: $394,216.87 Settle by paying cash ($)

So, to pay 5,000,000 pesos in six months time, if ZPS do money market hedge then the cost will be $394,216.87. Effective exchange rate will be $1 = 12.683 pesos (5,000,000/ $394,216.87).

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Money market hedge

Money market hedge: Foreign currency payment

Month 0 6 months $ borrowing rate: 2.25% Borrow: $385,542.17 Sell $: $385,542.17 Buy pesos: 4,819.277.11 pesos Deposit: 4,819,277.11 pesos 6 months peso deposit rate: 3.75% Month 0

Month 6 Liability with interest: $394,216.87

Settle by paying cash ($)

Deposit with interest: 5,000,000 pesos Month 6

Payment to settle 5,000,000 pesos liability

**If you find any error in this document or require any explanation, please write to mezbah.ahmed@hotmail.co.uk

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