Class notes for today:
Money market hedge we calculated amount of dollars we need to invest today (for 3
months) so that the investment grows to become exactly equal to the amount we
have to pay after 3 months.
1.So we calculated PV of $ 450,000 using deposit rate 5% (annual rate for 3 months
its equal to 5%*3/12= 1.25%) $450,000/1.0125= $ 444,444.
2. step 2: we will invest this amount in money market for 3 months at 1.25% and
after 3 month we will get $ 450,000 and we will make our payment.
3. so in order to remove exchange risk we’ll buy US $ 444,444 today at spot rate.
Look at spot rate in question its $1.7000 = 1 £ (Hint when in doubt about spot rate
use both rates and the rate giving higher amount for buying foreign currency will be
charged to you by bank)
US $ 444,444/1.7000 = £261,438
Here is the Catch:
We are going to borrow these pounds for 3 months from money market; Remember
we can borrow & lend for short term in money market.
-
Borrowing rate for sterling 7.5% per annum (for 3 months this would be
7.5%*3/12= 1.875%)
So the amount we have to return after 3 months is:
 £261,438*1.01875 = £ 266, 340 is the cost to create a money
market hedge for our Us $ 450,000 payment after 3 months.
 Now we certainly know the amount we have to expend in
pounds.
Now look at result of hedging from forward exchange contract;
Forward Exchange contract for Hedge:
If we enter into forward exchange contract with bank today for 3 months to buy US $
at 450,000 at affixed rate at the end of 3 months period; the bank has offered
following rates for 3 month forward contract today;
So we will buy US $ 450,000/1.6902 = £261,438 = £266, 240 in a forward exchange
contract with bank.
So which hedge is more effective? The answer is forward exchange hedge is slightly
cheaper here; there isn’t any huge difference between two answers reason is
Interest parity theory… can you link it? See you in next class