Assume the spot rate of the ? is $1.7000. The British interest rate is 10%, and
ID: 2619970 • Letter: A
Question
Assume the spot rate of the ? is $1.7000. The British interest rate is 10%, and the U.S. interest rate is 11% over the 360?day (1 year) period. The British inflation rate is 4% and the U.S. inflation rate is 3.5% over the 360-day (1 year) period. The 180-day forward price is $1.7200/?. The 180-day European call option on the $ with the exercise price of ?0.5800 is selling at 3% premium, while the 180-day European put option on the $ with the exercise price of ?0.5900 is selling at 2% premium. Your U.S. based firm has an account payable of ?200,000 due in 180 days. A) What should be the 180-day forward rate based on Interest Rate Parity (IRP)? What is the dollar cost of using a forward hedge? Make sure you state your position in the forward contract. B) Assume the firm has no excess cash. Use the above to calculate the dollar cost of using a money market hedge to hedge ?200,000 of payable due in 180 days? C) Calculate the cost of an option hedge at the time the payment is due assuming you exercise the option when the payment is due. D) Based on the answers in (a), (b), and (c), which hedging methods should your firm choose? Assume the spot rate of the ? is $1.7000. The British interest rate is 10%, and the U.S. interest rate is 11% over the 360?day (1 year) period. The British inflation rate is 4% and the U.S. inflation rate is 3.5% over the 360-day (1 year) period. The 180-day forward price is $1.7200/?. The 180-day European call option on the $ with the exercise price of ?0.5800 is selling at 3% premium, while the 180-day European put option on the $ with the exercise price of ?0.5900 is selling at 2% premium. Your U.S. based firm has an account payable of ?200,000 due in 180 days. A) What should be the 180-day forward rate based on Interest Rate Parity (IRP)? What is the dollar cost of using a forward hedge? Make sure you state your position in the forward contract. B) Assume the firm has no excess cash. Use the above to calculate the dollar cost of using a money market hedge to hedge ?200,000 of payable due in 180 days? C) Calculate the cost of an option hedge at the time the payment is due assuming you exercise the option when the payment is due. D) Based on the answers in (a), (b), and (c), which hedging methods should your firm choose? Assume the spot rate of the ? is $1.7000. The British interest rate is 10%, and the U.S. interest rate is 11% over the 360?day (1 year) period. The British inflation rate is 4% and the U.S. inflation rate is 3.5% over the 360-day (1 year) period. The 180-day forward price is $1.7200/?. The 180-day European call option on the $ with the exercise price of ?0.5800 is selling at 3% premium, while the 180-day European put option on the $ with the exercise price of ?0.5900 is selling at 2% premium. Your U.S. based firm has an account payable of ?200,000 due in 180 days. A) What should be the 180-day forward rate based on Interest Rate Parity (IRP)? What is the dollar cost of using a forward hedge? Make sure you state your position in the forward contract. B) Assume the firm has no excess cash. Use the above to calculate the dollar cost of using a money market hedge to hedge ?200,000 of payable due in 180 days? C) Calculate the cost of an option hedge at the time the payment is due assuming you exercise the option when the payment is due. D) Based on the answers in (a), (b), and (c), which hedging methods should your firm choose?Explanation / Answer
A) To determine forward exchange rate, following formula holds true
F = S * ((1 + if) / (1 + id)).
Where:
id is the interest rate in the domestic currency, or the base currency
if is the interest rate in the foreign currency, or the quoted currency
S is the current spot foreign exchange rate
F is the forward foreign exchange rate
F = 1.7000 * ((1+0.11*180/360) / (1+0.10*180/360))
= 1.7081
Dollar cost using a forward hedge = ?200000*1.7081 = $341620
B) The above dollar cost is calculated based on covered interest rate parity, therefore in case Money Market Hedge also the Dollar cost will be same i.e. $ 341620
C) The Dollar cost using European put option = (?200000/0.5900)*1.02 = $345763
D) The Firm should choose either Forward hedge or Money Market hedge.