Please show work step by step i believe that perhaps the borrow and invest rates
ID: 2622262 • Letter: P
Question
Please show work step by step i believe that perhaps the borrow and invest rates for swiss franc are supposed to be for euro. But am not sure. Euro rates make sense while the franc doesn't to me. Will award points to best and correct answer.
2. On March 1, 2014, Gulliver Radio of Los Angeles bought garage door radios from a French exporter for euro 800,000, receivable on October 31, 2014. Jonathan Swift, Gulliver's director of finance, wondered if he should protect the firm against a possible strengthening of the euro in the future. The euro is currently selling for $1.38/euro in the spot market. The eight-month forward exchange rate is quoted as $1.39/euro. Jonathan considers the following two choices:
Alternative 1: Hedge by a forward contract.
Alternative 2: Hedge by synthetic forward.
Gulliver can invest and borrow dollars at 0.45% and 3.0% per annum, and invest and borrow Swiss franc at 1.0% and 4.0% per annum, respectively. Which one is more advantageous between forward hedging and synthetic forward hedging? You need consider two alternative financial situations of Gulliver Radio.
Explanation / Answer
Yes, swiss franc rates are assumed to be those for euro.
Alternative 1: hedge by forward contract
As forward contract is selling at 1.39/euro, Gulliver will need to pay 800,000 * 1.39 = $ 1,112,000 in 8 months
Alternative 2: hedge by synthetic forward
800,000 euros in 8 months time is equivalent to 800,000 / (1+1%*8/12) = 794,702 euros today
794,702 euros are worth 794,702 * 1.38 = $ 1,096,689 today
Synthetic forward can be created by:
1. Borrowing $ 1,096,689 at 3% to buy 794,702 euros today
2. Investing this 794,702 euros at 1% p.a. which will grow to 800,000 in 8 months time
3. Repaying $ 1,096,689 * (1+3%*8/12) after 8 months time.
After 8 months, Gulliver will have to repay 1,096,689 * (1+3%*8/12) = $ 1,118,623
As we can compare the 2 options, clearly the alternative 1 (forward hedging) involves less outflow after 8 months, so it is more advantageous.
Hope this helped ! Let me know in case of any queries.