Artificial matching is a three stage process.

1. Calculate Present value (PV)

2. Change the amount in home currency
3. Calculate future value (FV)

EXAMPLE 1:
UK Company is exporting $100 million goods receivable in 6 months. Spot rate 1£ = 1.5$.
UK £ US $
Lending 5% 6%
Borrowing 7% 8%
What is effective conversion rate?

Solution:
Whenever a company needs to hedge, it must create receivable for every payable or
payable for receivables to meet the hedge conditions, as hedge is always bilateral. Here we
need to create a £ 100m payable account for the receivable amount.

Step 1: calculate PV of $100m using borrowing rate.

𝐹𝑉 = PV(1 + i)𝑛 , 100 = PV(1 + .08)1/2

𝐹𝑉
𝑃𝑉 = PV = 100 / (1 + .08)1/2 = 96.2250m $
(1+i)𝑛

Company should borrow 96.2250 m $ to pay 100m $ after 6 months.

Step 2: Change the amount in home currency ($ into £)

1£ = 1.5$ $ 96.2250m = £? , 96.2250 / 1.5 = £ 64.15m

Step 3: calculate FV for investable amount in the home currency at lending rate.
𝐹𝑉 = PV(1 + i)𝑛 , FV = 64.14(1 + .05)1/2 = £ 65.73m

What is effective rate at which it is actually replaced.

$ amount / £ amount = effective rate : $ 100 / £ 65.73 = $ 1.513 / £
It means £ 1 is replace with $1.5213

EXAMPLE 2:
A UK exporter has following transactions to be settled in following 6 months.

Exports Imports
A £ 500m ---
B $ 400m € 50m
C € 50m $ 200m

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Waseem A. Qureshi MM141063

Following are the lending, borrowing and inflation rates.
US $ UK £
Lending 8% 10%
Borrowing 10% 13%
Inflation 5% 8%
Spot rate 1.5 = 1
Q 1. What is effective exchange rate.
Q 2. Do they need to hedge.

Solution:
£ 500m receivable is an amount in home currency, so we don‘t need to hedge for this amount.
€ 50m is receivable and at the same amount is payable, so no need to hedge for this amount.
$ 400m is receivable and $ 200m is payable. So there is a need to hedge for this $ 200m
difference amount.

Step 1: calculate PV of $200m using borrowing rate.

𝐹𝑉 = PV(1 + i)𝑛 , 200 = PV(1 + .10)1/2

PV = 200 / (1 + .10)1/2 = 190.6925m $

Company should borrow 190.6925 m $ to pay 200m $ after 6 months.

Step 2: Change the amount in home currency ($ into £)

1£ = 1.5$ $ 190.6925 m = £? , 190.6925 / 1.5 = £ 127.1283m

Step 3: calculate FV for investable amount in the home currency at lending rate.
𝐹𝑉 = PV(1 + i)𝑛 , FV = 127.1283(1 + .10)1/2 = £ 133.33m

What is effective rate at which it is actually replaced?

200 / 133.33 = 1.5
It means £ 1 is replace with $1.50
Whether we need to hedge for this or not. It can be calculated by the inflation rate. We see
what will be effective exchange rate if we don‘t hedge.

PV (1+𝑖 𝑑 )𝑛 1.5(1+.05)1/2
𝐸𝑥𝑐𝑕𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 = = = $ 1.4790
(1+𝑖 𝑓 )𝑛 (1+.08)1/2

HINT: 𝑖 𝑑 is interest rate of domestic currency 𝑖 𝑓 is interest rate of foreign currency

The rate calculated through inflation is $ 1.4790/£ which is lower than 1.5, means we don‘t
need to hedge. If we convert $200 at 1.4790 per pound, we will get ($200 / 1.4790 = £ 135 m)
which is more than £ 133.33

This is the formula we use to calculate the future prices of currency.

HINT 2: sometimes direction of the currency becomes basis for decision. In depreciation
exporters don‘t need and importers must hedge to save their position.

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Waseem A. Qureshi MM141063

EXAMPLE 3:
Suppose for example 2, exports are replaced with imports. Do we need to hedge?

Imports Exports
A £ 500m ---
B $ 400m € 50m
C € 50m $ 200m

Following are the lending, borrowing and inflation rates.

US $ UK £
Lending 8% 10%
Borrowing 10% 13%
Inflation 5% 8%
Spot rate 1.5 = 1

Solution:
Now we need to invest those $ 200m for future payables.

Step 1: calculate PV of $200m using lending rate.

𝐹𝑉 = PV(1 + i)𝑛 , 200 = PV(1 + .08)1/2

Pv = 200 / (1 + .08)1/2 = 192.45m $

Company should invest 192.45m $ to pay $200m after 6 months.

Step 2: Change the amount in home currency ($ into £)

1£ = 1.5$ $ 192.45 m = £? , 192.45 / 1.5 = £ 128.30m

Step 3: calculate FV for investable amount in the home currency at borrowing rate.
𝐹𝑉 = PV(1 + i)𝑛 , FV = 128.30(1 + .13)1/2 = £ 136.3847m

What is effective rate at which it is actually replaced?

200 / 136.3847 = $ 1.4664
It means £ 1 is replaced with $1.4664
Decision: Importer should not hedge as it is lower than inflation exchange rate which is 1.4790

Financial Derivatives

Derivatives are the securities that extract their value from some underlying entity. This
underlying can be an asset, index or interest rate and is often called the ―underlying‖.
Derivatives can be used for a number of purposes, including insuring against price movements
(hedging), increasing exposure to price movements, for speculation or getting access to
otherwise hard to trade assets or markets. Some of the more common derivatives include
forwards, futures, options, and swaps.
The price of the underlying instrument, in whatever form, is paid before control of the
instrument changes.
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Waseem A. Qureshi MM141063