Question

A U.S. firm imports €10 million of goods from a German firm, and needs to pay the full amount to the firm in 6 months. This U.S firm is engaging in the money market hedge in order to eliminate the transaction exposure. The following rates are available to the US firm: 6 month US interest rates = 3%, 6 month German interest rates = 5%, and the spot exchange rate (S^$/€) = $1.20/€.

a. Describe the money market hedging strategy for the US firm. Be specific

b. Now, suppose that the six month forward rate is available to the US firm at the rate of $1.20/€. Describe the forward hedging strategy to cover the €10 million payables. Be specific.

c. Which hedging strategies (money market hedge or forward hedge) would be better (less expensive) to employ? Explain why.

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Answer 1

DATE Anwera US German Payables = € 1o million spot rate Time 6mths 1€ - 1.20$ ♡ Money Market US Interest German Interest 3.1. st Helge procedure borrow from us and Drvest in Ger Germany Let amt to be Invested in be a germany then, a (4) X ( S% [ 6 12 = € lo millim 20 = € 1o million € 9.756 million 1.025 Convut Above amt in $ and borrow. DS Payates (in $) After 6mthe € 9.756 million (x) 120$ (H 9.75 to million € (01.20$ * 3) 6 no 1 l as $11.7672 million (t) $0.1756 million $ 11.8828 million Payables (condy Mno): $11.88 20 million Scanned with Callassmate er PAGE

DATE 21 forward Rate 1€ = $1,20 Payables under forward Hedge € lomillon (x) $1.20 $ 12 milim under Mroz & 12 million Payables $ 11.8828 million Payable under forward = Since payables are least under money market Hedge money market hedge is better. hence Ics Scanned with CamScanner