1.

Money Market Receivables Hedge

A large U.S. manufacturing company exports mining machinery to England. Each piece of machinery sells for 1 million and is payable in 1 year. U.S. interest rate is 6% England interest rate is 8.5% Spot exchange rate is $1.60/ 1 year forward exchange rate is $1.56/

In order to hedge against foreign exchange rate risk you need to: 1. Borrow the present value of the foreign currency. In order to determine the present value of 1 million we discount it by the current foreign interest rate. PV =1,000,000 :1.085 =921,659 2. Covert the amount borrowed into domestic currency at the current spot rate. $1.60 x 921,659 = $1,474,654 3. Invest the $1,474,654 in the United States. 4. In 1 years time receive the 1 million and repay the loan. 5. Receive the 1 year maturity value of the amount invested in the United States. $1,474,654 x 1.06 = $1,563,134 We end up with $1,563,134. If we compare this to the amount that the company would have received if they had taken out a forward contract they would receive $1,560,000. So both ways you end up with roughly the same amount. It doesnt matter if the future spot rate falls below $1.56/, because by using the money market you are guaranteed $1,563,134.

Meskovic Alen 4A Sarajevo

2. Money Market Payables Hedge

A large U.S. manufacturing company imports engines for their mining machinery. Each piece of engine costs 500,000 and is payable in 1 year. U.S. interest rate is 6% Germany interest rate is 6.7% Spot exchange rate is $1.60/ 1 year forward exchange rate is $1.55/

In order to hedge against foreign exchange rate risk you need to: The company will want to borrow from the country with the lowest interest rate and invest in the country with the highest interest rate. Therefore they will choose to borrow domestically from U.S and invest internationally in Germany. 1. Determine the present value of the foreign currency. In order to determine the present value of 500,000 we discount it by the current foreign interest rate. PV= 500,000 /1.067= 468,604 2. Invest the present value of 500,000, (468,604) in the Germany interest rate at 6.7%. Upon maturity they will receive 500,000 to repay the account. 3. They will need to invest the 468,604 in the U.S market . Convert this amount into U.S. dollars at the current spot rate to determine the amount needed to be borrowed domestically. 468,604 x $1.60 = $749,766 4. Determine the future value of the loan that must be repaid. $749,766 x $1.06 = $794,752 5. This should be enough to repay the 500,000 loan in 1 year. We can check my converting it back into the Euros at the expected 1 year future spot rate. $794,752 x 1/1.55= 512,743

Meskovic Alen 4A Sarajevo