be billed 20 million which is payable in one year. The current spot exchange rat
ID: 2784125 • Letter: B
Question
be billed 20 million which is payable in one year. The current spot exchange rate is $1.05(€ and the one-year forward rate is S 1.10€. The annual interest rate is 6.0% in the U.S. and 5.0% in France. Boeing is concerned with the volatile exchange rate between the dollar and the euro and would like to hedge exchange exposure. (a) It is considering two hedging altematives: hedging with forward contract or money market instruments. b) What is the dollar revenue if the foreign exchange risk is hedged with forward contract? (c) Howto hedge the foreign exchange risk with money market instruments? (d) What is the dollar revenue if the foreign exchange risk is hedged with money market instruments? (e) Which hedging strategy is preferred? Other things being equal, at what forward exchange rate would Boeing be indifferent between the two hedging methods?Explanation / Answer
b. Dollar revenue on sale at spot price= 20M Euro* 1.05= 21M USD
On settlement date foreign exchange gain= (1.1-1.05)* 20M= 1M USD
c. Hedging with money market instruments:
Take a loan in the currency in the currency of receipt to match the maturiy payable amount with the receipt in foreign currency, when loan is due pay with foreign currency received.
Hedging process:
20M Euro will be received after 1 year, so take a loan in EURO which at maturity along with interest will be 20M, hence loan amount today at 5%= 20 000 000/(1+0.05)= 19047619
this loan will be repaid when Air france makes payment, hence currency risk eliminated
if the Euro amount is converted to USD today at spot rate= 19047619*1.05= USD 20 000 000
When USD amount is lent at current interest rate after 1 year USD20M= 20 000 000* 1.06= 21 200 000USD
d. Dollar revenue when risk is hedged with money market instrument= 21 200 000
e. total revenue under forward contract 22M is higher than total revenue under money market hedge of 21.2M
Hence forward contract method is preferred
e. under money market hedge 21.2M is received if under forward contract 21.2M is received then company will be indifferent, following rate will be= 21 200 000/ 20 000 000= 1.06 USD/EUR
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