Farah Jeans of San Antonio, Texas, is completing a new assembly plant near Guate

Question

Farah Jeans of San Antonio, Texas, is completing a new assembly plant near Guatemala City. A final construction payment of Q8,400,000 is due in six months. (“Q” is the symbol for Guatemalan quetzals.) Farah uses 20 percent per annum as its weighted average cost of capital. Today’s foreign exchange and interest rate quotations are as follows:

Construction payment due in six months (A/P, quetzals)

8,400,000

Present spot rate (quetzals/$)

7.0000

Six-month forward rate (quetzals/$)

7.1000

Guatemalan quetzal six-month interest rate (per annum)

14.000%

U.S. dollar six-month interest rate (per annum)

6.000%

Farah's weighted average cost of capital (WACC)

20.000%

Farah's treasury manager, concerned about the Guatemalan economy, wonders if Farah should be hedging its foreign exchange risk. The manager's own forecast is as follows:

Highest expected rate

8.0000

Expected rate

7.3000

Lowest expected rate

6.4000

What realistic alternatives are available to Farah for making payment? Which method would you select? Give reasons for your answer.

Construction payment due in six months (A/P, quetzals)

8,400,000

Present spot rate (quetzals/$)

7.0000

Six-month forward rate (quetzals/$)

7.1000

Guatemalan quetzal six-month interest rate (per annum)

14.000%

U.S. dollar six-month interest rate (per annum)

6.000%

Farah's weighted average cost of capital (WACC)

20.000%

Explanation / Answer

Amount to be paid under No hedging

Construction payment due in six months (A/P, quetzals) = 8,400,000

Six-month forward rate (quetzals/$) = 7.1

Amount to be paid after six month = 1183098

Alternative= Money market hedge

Amount of Q to be invested today in Guatemalan quetzals money market @ 14% p.a. for 6 months = 8400000 / (1 + 1*14%*0.5) = 7850000

Spot rate = 7

Amount of $ to be borrowed today in order to purchase Q 785000 today at spot rate= 1121428

Add- interest payable for 6 month = 33642

Amount to be paid at end of 6 month = 1155070

Gain from money market hedging = 1183098 = 1155070 = 28028

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