Alcoa, a U.S. firm, has signed a contract to purchase goods from a manufacturer

Question

Alcoa, a U.S. firm, has signed a contract to purchase goods from a manufacturer in Germany for €5,000,000. The purchase was made in June with payment due six months later in December. The following market quotes are available:

o The spot exchange rate is $1.20/€

o The six month forward rate is $1.21/€

o The Euro zone 6-month borrowing rate is 7%

o The Euro zone 6-month deposit rate is 5%

o The U.S. 6-month borrowing rate is 6%

o The U.S. 6-month deposit rate is 4%

(a) Calculate the six-month forward premium/discount for euros. Show your calculations.

(b) If Alcoa chooses to hedge its transaction exposure in the forward market at the available rates, what will be the required amount in dollars to pay off the accounts payable in six months? Show calculations to support your answer.

(c) If Alcoa chooses to hedge its transaction exposure in the money market at the available rates, what will be the required amount in dollars to pay off the accounts payable in six months? Explain the steps and show calculations to support your answer. Would Alcoa be better off using a forward hedge or a money market hedge?

Explanation / Answer

a) 6 month forward premium/(discount) = (1.21/1.20)-1 = 0.83% b) FORWARD CONTRACT: Amount payable under the forward contract = E5000000*1.21 = $         60,50,000.00 [1] c) MONEY MARKET HEDGE: Under the MMH, the firm should create a Euro asset which will be equal to Euro 5000000 at the end of 6 months. Steps to be taken on day 1: Amount to be deposited in Euro = 5000000/1.05 = $         47,61,904.76 Euro Amount to be borrowed in $ to get the required funds in Euro = 4761904.7*1.20 = $         57,14,285.71 Maturity value of the $ Loan at the end of 6 months = 5714285.71*1.06 = $         60,57,142.86 Steps to be taken on due date: Collect the Euro 5,000,000 from the deposit made and pay the amount due for the purchase, which is also Euro 5,000,000 Pay the $ loan which will then have a maturity value = $         60,57,142.86 [2] (Cost under the MMH) OF THE TWO ALTERNATIVES THE FORWARD CONTRACT OFFERS THE LEAST COST ALTERNATIVE.

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