1. (This problem is worth 4 of the 10 points in this assignment). Assume that a
ID: 2736376 • Letter: 1
Question
1. (This problem is worth 4 of the 10 points in this assignment). Assume that a U.S. firm has ordered a major piece of machinery from a Japanese firm for ¥3 million, and that the current exchange rate is 106 ¥/$ (i.e., the current cost of the machinery in dollars is $28,302). The payment for the machinery, to be made in Yen, is due in 6 months and the firm will borrow at its bank at a 6% p.a. rate . The U.S. firm is concerned about appreciation of the Yen, which would lead to a greater cost than planned. Therefore, the firm is considering twopossible transactional hedges: (1) entering into a forward contract, or (2) creating a money market hedge. REQUIRED: a. Explain what exact steps the firm should take in each of the possible hedges (i.e., what positions). Assume that 6-month forward contracts are currently available at an exchange rate of 103.5¥/$; the relevant interest rate in Japan is 3% p.a. (1/2 point) b. You learned from week 6 that both the money market hedge and the forward hedge lock in the cost of the machinery. What is that cost to the U.S. firm (in dollars) in 6 months? Show your work. (2 points) c. Which hedge would be the best choice? Hint: There is less than $300 difference between the two choices. (1/2 point) d. By what amount would the firm be better or worse off if it simply paid for it today? To be consistent you need to consider the time value of money and we will assume the 6% rate as the opportunity cost of paying today rather than in 6 months. (1 point)
Explanation / Answer
1) Entering into a forward contract:
The firm has to enter into the 6 month forward contract with a foreign exchange dealer for the purchase of Y 3 million, the rate being 103.5Y/$.
On the date of payment (ie: after 6 months), the firm will buy Y3,000,000 paying 3000000/103.5 = $28,986 and settle the dues.
2) Creating a Money market hedge:
As the firm has a liability in Y of 3,000,000 it should create an asset in Y, which would have a value of Y3,000,000 in 6 months. For this it will have to borrow money in $ and deposit in Y.
The following steps have to be carried out:
i) Borrow $27,883.63 at 3% (for 6 months-half of 6%). The total amount payable after 6 months would be 27884.63*1.03 = $28,720.14
Amount to be deposited is Y3000000/1.015 = 2,955,665
Amount to be borrowed = 2955665/106 =$27,883.63
ii) Convert the amount borrowed into Y, get 27883.63*106 = Y2,955,665 and invest at a rate of 1.5%. Maturity amount would be 2955655*1.015 = Y3,000,000
The above steps are to be carried out on day 1 (today).
On the date of payment (6 months later) the firm would
i) realise the deposit in Y which has a maturity value of Y3,000,000 and pay the dues of the Japanese supplier (Y3,000,000).
ii) pay the $ loan with interest-- total $28,720
The cost to the firm in $ terms would be 28720.
c) The money market hedge is the best choice as the outflow after 6 months is less, when compared to the outflow under the forward contract.
d) $ outflow as of today if payment is made today = 3000000/106 = $28302
Value of the payment after six months = 28302*1.03 = $29,151. If the payment is made today the firm would lose 29151-28720 = $431.
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