Suppose a U.S. firm buys $200,000 worth of stereo wire speaker from a Mexican ma

Question

Suppose a U.S. firm buys $200,000 worth of stereo wire speaker from a Mexican manufacturer for delivery in 60 days with payment to be made in 90 days (30 days after the goods are received). The rising U.S. deficit has caused the dollar to depreciate against the peso recently. The current exchange rate is 5.50 pesos per U.S. dollar. The 90-day forward rate is 5.45 pesos/dollar. The firm goes into the forward market today and buys enough Mexican pesos at the 90-day forward rate to completely cover its trade obligation. Assume the spot rate in 90 days is 5.30 Mexican pesos per U.S. dollar. How much in U.S. dollars did the firm save by eliminating its foreign exchange currency risk with its forward market hedge?

Please show all work step by step. Thanks

Explanation / Answer

1) Value of Imports in peso on the date of entering into the purchase contract = 200000 * 5.5 = 1,100,000 pesos

2) Amount paid in $ to obtain 1,000,000 pesos on the 90th day = 1,100,000/5.45= $201,834.86

   the rate of 5.45 pesos per dollar according to the forward rate.

3) Amount that would have been payable in dollars if there

   were no forward contract                                                     = 1,100,000/5.3 = $ 207547.17

4) Therefore, savings in $ by going for the forward hedge

    to mitigate foreign currency risk    Value at (3) - Value at (2) above               = $ 5,712.31                                    

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