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Money Mark e t Rece ivab les Hedge

M oney M ark e t H edge Fo rm u la

FX is f o r e ign cu r r encyrFX is the f o r e ign i n t e r es t r a t erD is the f o r e ign i n t e r es t r a t eST is t oday s spo t p r i ce

An alternative way to hedge besides entering into a forward contract is to

use the money market. This is simply the process of borrowing in onecurrency and lending in another.

A large U.S. manufacturing company exports mining machinery to

England. Each piece of machinery sells for 1 million and is payable in 1year.

U.S. interest rate is 6% England interest rate is 8.5% Spot exchange rate is $1.60/ 1 year forward exchange rate is $1.56/

In order to hedge against foreign exchange rate risk you need to:

1. Borrow the p res en t v a lue of the f o re i gn c u r renc y.In order to determine the present value of 1 million we discount it

by the current foreign interest rate.

PV 1,000,0001.085 921,659

2. Covert the amount borrowed into domestic currency at the currentspot rate.

$1.60 921,659 $1,474,6543. Invest the $1,474,654 in the United States.4. In 1 years time receive the 1 million and repay the loan.5. Receive the 1 year maturity value of the amount invested in the

United States.$1,474,654 1.06 $1,563,134

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We end up with $1,563,134. If we compare this to the amount that thecompany would have received if they had taken out a forward contract

they would receive $1,560,000. So both ways you end up with roughly

the same amount.

It doesnt matter if the future spot rate falls below $1.56/, because by

using the money market you are guaranteed $1,563,134.

Exam ple 1

The Boeing U.S Corporation exported a Boeing 747 to Australia. The aircraft wassold for $AUS8 million. The current spot rate in U.S terms is $US1.30/$AUS.The 1 year forward exchange rate is $US1.25/$AUS. The current interest ratesin the U.S and Australia are 5% and 9% respectively. How can Boeing hedgeagainst the risk of falling exchange rates by using the money market? What isthe amount they will receive in 1 year and what will be gain or loss incurred forusing the money market:

a. The spot rate in 1 year turns out to be $US1.19/AUS$b. The spot rate in 1 year turns out to be $US1.36/AUS$

1. Borrow the p r esen t va lue of the foreign currency.In order to determine the present value of 1 million we discount it by thecurrent foreign interest rate.

PV $AUS 8,000,0001.09 $AUS 7,339,449.50

2. Convert the amount borrowed into domestic currency at the current spotrate.

$US 1.30 $AUS 7,339,449.50 $US $9,541,284.403. Invest the $US 9,541,284.40 in the United States4. In 1 years time receive the 1 million and repay the loan.5. Receive the 1 year maturity value of the amount invested in the United

States.$US 9,541,284.4 1.05 $US 10,018,348.60

After 1 year Boeing will receive $US10,018,348.60

a. If Boeing did not use the money market to hedge against the risk offalling exchange rates and the spot rate fall to $1.19/AUS they wouldhave received $9,520,000. By using the money market to hedge theirrisk they have saved $498,348.60 ($10,018,348.60 - $9,520,000).

b. If the spot rate in 1 year turns out to be $US1.32/$AUS then Boeing couldhave potential received $10,880,000, thus missing out on $861,651.40($10,018,348.60 - $10,880,000).

R em em ber , t he po in t o f hedg ing i s no t t o m ax im is e p ro f i t s , bu t

ra t he r i t i s t o r educ e los s.

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Money Mar k e t Payab les Hedge

A large U.S. manufacturing company imports engines for their mining

machinery. Each piece of engine costs 500,000 and is payable in 1 year.

U.S. interest rate is 6% Germany interest rate is 6.7% Spot exchange rate is $1.60/ 1 year forward exchange rate is $1.55/

In order to hedge against foreign exchange rate risk you need to:

The company will want to borrow from the country with the lowestinterest rate and invest in the country with the highest interest rate.

Therefore they will choose to borrow domestically from U.S and investinternationally in Germany.

1. Determine the p res en t v a lue of the f o re i gn cur rency .In order to determine the present value of 500,000 we discount it

by the current foreign interest rate.

PV 500,0001.067 468,604

2. Invest the present value of 500,000, (468,604) in the Germanyinterest rate at 6.7%. Upon maturity they will receive 500,000 torepay the account.

3. They will need to invest the 468,604 in the U.S market . Convertthis amount into U.S. dollars at the current spot rate to determine

the amount needed to be borrowed domestically.

468,604 $1.60 $749,7664. Determine the f u t u r e v a l u e of the loan that must be repaid.

$749,766 $1.06 $794,7525. This should be enough to repay the 500,000 loan in 1 year. We

can check my converting it back into the Euros at the expected 1year future spot rate.

$794,752 11.55 512,743

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Exam ple 2

The Boeing U.S. Corporation imports engine jets for its Boeings 747 aircrafts.The jet engine costs 400,000, is imported from Germany, and is payable in 1

year. The current spot rate in U.S. terms is $US1.34/. The 1 year forward

exchange rate is $US 1.25/. The current interest rates in the Australia andGermany are 5% and 9% respectively. How can Boeing hedge against the risk offalling exchange rates by using the money market? What is the amount they willreceive in 1 year and what will be gain or loss incurred for using the moneymarket:

Australia has the lowest interest rates so Boeing will want to bo r r owdom es t i ca l l y and i n ves t i n t e r na t i ona l l y in the German market.

1. Determine the p r esen t va lue of the f o r e ign cur rency .In order to determine the present value of 400,000 we discount it by thecurrent foreign interest rate.

PV 400,0001.09 366,972

2. Invest the present value of 400,000, (366,972) in the Germany interestrate at 9%. Upon maturity they will receive 400,000 to repay theaccount.

3. They will need to invest this 366,972 in the U.S market. Convert thisamount into U.S. dollars at the current spot rate to determine the amountneeded to be borrowed domestically.

366,972 $1.34 $491,7434. Determine the f u t u r e va lue of the loan that must be repaid.

$491,743 $1.05 $516,3305. This should be enough to repay the 500,000 loan in 1 year. We can

check by converting it back into the Euros at the expected 1 year futurespot rate.

$516,330 11.25 413,064