This question is similar to one that you saw on your second assignment. Your ans

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This question is similar to one that you saw on your second assignment. Your answer to the question may now be different, however, and there are some differences in the question and its emphasis. Suppose a U.S corporation bids for the right to import a machine from Europe, and if it wins the bid will need to pay 1 million Euros in 90 days' time. What position has the importer taken in Euros, if any, and what currency risk is the importer concerned about? Discuss the alternative foreign exchange instruments available to this corporation in hedging this risk, if any, and the costs and benefits of each. Suppose that the U.S. corporation learns that it has won the contract to import the machine. Assuming that it did not hedge through any of the alternatives you discussed in a), what position does it have now in Euros, if any? Consider two alternative hedging strategies for the; one is to buy Euros 90 days forward and the other is to borrow dollars for 90 days, use them to buy and lend Euros for 90 days, and use the proceeds of the Euro loan to pay the Euro obligation in 90 days' time. Explain these two alternatives in detail, assuming that the firm receives the machine in the US and can sell it within the 90 day period of trade credit, and argue that they are equivalent.

Explanation / Answer

A-If US Corporation Win the Bid then it has to buy Machine and pay 1 million euro at 90 days time. By purchasing the machine US Corporation has incurred Payble Exposure in Euro, hence it has obligation to pay 1 million euro in 90 days.

Importer is concerned about Currency flactuation Risk of Euro and Dollor currency. Exchange Flactuation risk can be hedged by using foreign currency Instruments. it can be

1- Forward Hedge- It is instrument for hedge in which importer has to made a contract with banker to buy 1 million Euro at 90 days forward rate. Forward rate has been offered by bank which will be based on Current Exchange rate plus fprward Premium. the Benefit of Forward instrument is that Importer has fixed the Payment of Euro in Dallor at contractted rate irrespective of whatever is actual exchange rate prevailing on that date.

2- Money Market Hedge- Under this instrument Importer of US has to borrow money from a bank in USA in dallor currency based on Interest Rate and take the proceeds of borrowing to Europe and deposit in bank for 90 days.

At 90 days proceed of deposit in europe will equal to payble exposure and by this amount paid to supplier. By this instrument importer has hedged it risk of flactuation by borrowing today in dallor.

B- If Importer does not hedge its Currency Risk then there are two possibilities at 90 days-

1- If Actual Exchange rate at 90 days is less than today spot Rate then importer will benefitted from not hedging because at 90 days has has to pay less dallor than today.

2- If Actual Exchange rate at 90 days is more than Expected spot Rate then importer will lose from not hedging because he has to pay more dallor than expected.

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