Use the following information for questions 8-15 S-$1.52/, and f360-$1.55/£ If i

Question

Use the following information for questions 8-15 S-$1.52/, and f360-$1.55/£ If ih = 8%, if-696, Hedging Account Pavables: 8) If you use the Money Market to hedge a £100,000 A/P exposure, what are steps? How much you need to invest? And Where? . How much you need to borrow? And Where? 9) What is the cost of the Money Market Hedge? 10)If you use the forward market to hedge, will you BUY or SELL the Pounds forward? 11) What is the cost of the Forward Hedge? 12) Would you prefer to hedge the A/P in the forward market or the money market? Why? Hedging Account Receivables: 13) Rather than hedging a £100,000 A/P, assume that you want now to use the Money Market to hedge a £100,000 A/R exposure, what are steps? How much you need to borrow? And Where? How much you need to invest? And Where? 14)If you use the forward market to hedge, will you BUY or SELL the Pounds forward? 15) Would you prefer to hedge the A/R in the forward market or the money market? Why?

Explanation / Answer

ih = 8% if = 6% S = 1.52 F (360) = 1.55 8) Money market hedge Step 1 = Since we have accounts payable pound 100000 after a year We need to invest such amount of pound today so that it will provide an inflow of Pound 100000 after a year Amount of pound to be invested today = 100000/(1.06)         = £     94,339.62 Step 2 = Amount to be borrowed today in $ to invest Pound 94339.62 = $ required = 94339.62 x 1.52 = $ 1,43,396.23 Step 3 - $ outflow after 1 year = 143396.23 x (1.08) = $ 1,54,867.92 9) Cost of money market hedge = interest payable on borrowings i.e. $ 1,54,867.92 - $ 1,43,396.23 = $     11,471.70 10) Forward market hedge = Buy pounds payable @ 1.55/ pound = Outflow in $ = (100000 x 1.55) $ 1,55,000.00 11) Cost of forward hedging = is the premium paid on forward contract forward hedging cost = [(F - S1)/n] x 360 x 100 = Here we are not provied with S1 i.e. spot rate on payment date therefore forward cost cannot be determine 12) Outflow is lower in money market therefore money market hegding should be implemented. 13) Money market hedge - Step -1 Borrow the currency that is recievable (i.e. Pound 100000) - Amount to be borrowed is such that pound payable at the end will be equal to pound recievable - Rate of intereset = 6% Amount to be borrowed = 100000/(1.06)        = £     94,339.62 Step 2 - Convert this amount borrowed today at $1.52/pound getting - 94339.62 x 1.52 = $ 1,43,396.23 Step 3 - Invest the $ amount @ 8% - Inflow at the end of period = 143396.23 x 1.08              = $ 1,54,867.92 14) Forward market hedge - Sell pound recivables @ 1.55 Inflow at the end of period = 100000 x 1.55              = $ 1,55,000.00 15) Forward market provides more cash inflow therefore it should be implemented. I have assumed that the rates given are for 360 days. If they are annual you need to use (1.06)^360/365 instead of 1.06 in step 1 of part 1, also (1.08)^360/365 instead of 1.08 in step 2. Please provide feedback… Thanks in Advance :-)

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