Question

Use the following information to calculate the dollar cost of using a money market hedge to hedge 200,000 British pounds of payables due in 180 days. Assume the firm has no excess cash. Assume the spot rate of the pound is $2.02, and the 180-day forward rate is $2.00. The British interest rate is 5 percent, and the U.S. interest rate is 4 percent over the 180-day period.

Answer 1

Answer:

The dollar cost of using a money market hedge to hedge 200,000 British pounds of payable due in 180 days is $400,152.38.

Explanation:

A money market hedge refers to a method that employed to to preserve the value of a foreign currency transaction in the domestic currency of a company in order to reduce the exchange rate or currency risk that is associated with business transactions with a foreign company.

For this question, the dollar cost of using a money market hedge can be calculated as follows:

Amount needed to invest in British pounds = Amount needed to hedge / (1 + British interest rate) = £200,000 / (1 + 0.05) = £190,476.19

Since this is in British pounds, we have to convert to the US dollars to obtain the amount of the US dollars that is needed to exchange as follows:

Amount needed to invest in the US dollars = Amount needed to invest in British pounds * Spot rate of the pound = £190,476.19 * $2.02 = $384,761.90

We can now calculate the amount needed to repay loan after 180-day as follow:

Amount needed to repay loan after 180-day = Amount needed to invest in the US dollars * (1 + U.S. interest rate) = $384,761.90 * (1 + 0.04) = $400,152.38

Therefore, the dollar cost of using a money market hedge to hedge 200,000 British pounds of payable due in 180 days is $400,152.38.