Hedging exchange rate risk The current level of real estate prices in Moscow see

Question

Hedging exchange rate risk

The current level of real estate prices in Moscow seem to be on a reasonable level now and you consider that this is just the right time to step into the market. You have noticed a nice apartment in the Leninsky Prospekt close to the city centre. The price for the apartment is $1.50 million. However, due to tax reasons you could buy that apartment only after 6 months. Currently you have sufficient funds deposited in a bank in Cypros (in euros). The annual yield on a bank deposit is 2.6%. Another option would be to convert a certain amount into dollars and deposit these funds into another bank with the annual yield of 1.5%. The spot exchange rate is 1.1741 EUR/USD (see the quote conventions from the lecture slides) and the 6m forward rate is quoted with premium equal to 95 basis points.

So, you have two options of how to pay for the apartment:

a) Buy a forward contract for buying dollars against euros in six months (and continue to deposit euros)

b) Invest enough dollars for dollar deposit already today and hedge your exchange rate exposure in this way

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Questions:

1. Try to show with calculations, which option has the lowest present value cost for you in euros?

2. Compute the correct forward rate implied by the interest rates.

Explanation / Answer

Convert Now Convert after six month USD EURO EURO required               17,48,040                               17,55,065 $ initially required               14,88,834 Half yearly rate 0.75% 1.30% Interest=1500000*.75%/100.75%                     11,166                                     22,816 EURO required 1500000*1.85254                               17,77,881 $ after six month               15,00,000                               15,00,000 Calculation of after six month forward rate Current conversion rate                 1.174100 EURO/USD Adding 95 basis point 1.1741+1.1741*.0095                 1.185254 EURO/USD 1 Since Euro required in case of convert into USD now is lesser this option to be preferred 2 Forward rate is 1.185254EUR/USD

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