Question

This question is related to Foreign exchange and international finance. Thanks, and definite thumbs up for answers!

2 pts )\Question 29 Questions 23-36 are based on the following information: Transaction Exposure Problem: (34 points in total) Suppose that you (i.e., company XYZ) are a US-based importer of goods from Canada. You expect the value of the Canada to increase against the US dollar over the next 6 months. You will be making payment on a shipment of imported goods (CAD100,000) in 6 months and want to hedge your currency exposure. The US risk-free rate is 5% and the Canada risk-free rate is 4% per year. The current spot rate is $1.25/CAD, and the 6-month forward rate is $1.3/CAD. You can also buy a 6-month option on Canadian dollars at the strike price of $1.4/CAD for a premium of $0.10/CAD By comparing forward hedge and money market hedge, which strategy (forward/MMI) would you prefer to use?

Answer 1

Amount Payable = CAD 100,000

Forward rate = $1.3/CAD

The guaranteed cost under forward contract = 100,000*1.3

= $130,000

Rate fixed under forward contract = $1.3/CAD

Actual spot rate on maturity = $1.4/CAD, hence more amount would have been payable

Hence, XYZ would be BETTER-OFF using forward hedge

Since the amount is payable after 6 months

Under money market hedge, following transactions will be undertaken:

Buy PV of CAD using USD, and deposit CAD in the bank and sit on it

The amount will reach the amount payable on maturity after interest and will be paid for the shipment

Amount required in CAD today = 100,000/(1+0.04*6/12)

= CAD 98,039.2156

Hence, amount in USD required to buy CAD 98,039.2156

= 98,039.2156*1.25

= $122,549.02

The dollar will be borrowed at 5% interest, hence guaranteed dollar cost

= 122,549.02(1+0.05*6/12)

= $125,612.75

The guaranteed cost under forward contract = 100,000*1.3

= $130,000

The guaranteed cost under Money Market Hedge = $125,612.75

Hence, MMH is preferable since lower cost