- 8 Marks
FM – L2 – Q90 – Foreign exchange risk and currency risk management
Question
The treasurer of Eurotrade Company wants to hedge an exposure to currency risk. Eurotrade is a company whose domestic currency is the euro, and the company must make a payment of US $500,000 to a US supplier in six months’ time.
The following market rates are available:
Exchange rates: $ per €1
| Spot | 1.604 ± 0.002 |
| 6 months forward | 1.570 ± 0.004 |
Six month interest rates
| Borrowing | Deposits | |
|---|---|---|
| Euro | 4.8% | 4.4% |
| US dollar | 2.5% | 2.0% |
(These interest rates are expressed as an annual rate of interest.)
Required
Compare the cost of hedging the currency risk exposure with:
(a) a forward exchange contract (3 marks)
(b) a money market hedge. (5 marks)
Recommend which method of hedging would be preferable in this situation.
Answer
Forward exchange contract
The six-month forward rate is 1.566–1.574.
Eurotrade would need to buy $500,000, and the bank would charge a rate of $1.566.
The cost to Eurotrade in euros in six months’ time = 500,000 / 1.566 = €319,285.
Money market hedge
The spot exchange rate is 1.602–1.606.
Eurotrade could borrow euros now, convert them into dollars and put the dollars on deposit for six months.
The six month interest rate for US dollar deposits = 2.0% × 6 / 12 = 1.0%.
To have $500,000 in six months’ time, Eurotrade would need to deposit:
$500,000 × (1 / 1.01) = $495,050.
The cost in euros of buying $495,050 spot = 495,050 / 1.602 = €309,020.
It is assumed that the euros to purchase the dollars spot would be obtained by borrowing for six months at 4.8%. Interest for six months would be 4.8% × 6 / 12 = 2.4%.
The cost in euros to Eurotrade of a money market hedge, for comparison with the cost of a forward contract, would therefore be:
€309,020 × 1.024 = €316,436.
Comparison of hedging methods
A money market hedge would be less expensive in this case, recommended as the method of hedging the currency risk exposure.
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