- 8 Marks
FM – L2 – Q90 – Foreign exchange risk and currency risk management
Compare costs of hedging Eurotrade's $500,000 payment using forward contract vs. money market hedge.
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.
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