Question

Hedging Payables. Assume the following information:

      90‑day U.S. interest rate = 4%

      90‑day Malaysian interest rate = 3%

      90‑day forward rate of Malaysian ringgit = $.400

      Spot rate of Malaysian ringgit = $.404

      Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit in 90 days. It wishes to hedge this payables position. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated costs for each type of hedge.

Answer 1

ANSWER: If the firm uses the forward hedge, it will pay out 300,000($.400) = $120,000 in 90 days.

If the firm uses a money market hedge, it will invest (300,000/1.03) = 291,262 ringgit

Now in a Malaysian deposit that will accumulate to 300,000 ringgit in 90 days. This implies that the number of U.S. dollars to be borrowed now is (291,262 × $.404) = $117,670. If this amount is borrowed today, Santa Barbara will need $122,377 to repay the loan in 90 days (computed as $117,670 × 1.04 = $122,377).

In comparison, the firm will pay out $120,000 in 90 days if it uses the forward hedge and $122,377 if it uses the money market hedge. Thus, it should use the forward hedge.