Ex change Rat es – Money Mar k et Hedge

© 2010 ht t p: / / w w w .w eal l st ar t somew her e.com
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Money Mar k et Recei v abl es Hedge

Money Mar k et Hedge For mul a

CF un maturtty = _
FX
1 + r
FX
] × S
T
× (1 + r
D
)

FX is f or ei gn cur r ency
r
FX
is t he f or ei gn i nt er est r at e
r
D
is t he f or ei gn i nt er est r at e
S
T
is t oday’ s spot pr i ce

An alt ernat ive way t o hedge besides ent er ing int o a forward cont ract is t o
use t he money market . This is simply t he process of borrowing in one
currency and lending in anot her.

A large U. S. manufact uring company export s mining machinery t o
England. Each piece of machinery sells for €1 million and is payable in 1
year.
 U. S. int er est rat e is 6%
 England int erest rat e is 8. 5%
 Spot exchange rat e is $1. 60/ €
 1 year forward exchange rat e is $1. 56/ €

I n order t o hedge against foreign exchange rat e r isk you need t o:

1. Borr ow t he pr esent v al ue of t he f or ei gn cur r ency.

I n order t o det ermine t he present value of €1 million we discount it
by t he current foreign int er est rat e.

Pv =
€1,uuu,uuu
1.u8S
= €921,6S9

2. Covert t he amount borrowed int o domest ic currency at t he cur rent
spot rat e.
$1.6u × €921,6S9 = $1,474,6S4

3. I nvest t he $1, 474, 654 in t he Unit ed St at es.

4. I n 1 year’s t ime receive t he €1 million and repay t he loan.

5. Receive t he 1 year mat ur it y value of t he amount invest ed in t he
Unit ed St at es.
$1,474,6S4 × 1.u6 = $1,S6S,1S4


Ex change Rat es – Money Mar k et Hedge

© 2010 ht t p: / / w w w .w eal l st ar t somew her e.com
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We end up wit h $1, 563, 134. I f we compare t his t o t he amount t hat t he
company would have received if t hey had t aken out a forward cont ract
t hey would receive $1, 560, 000. So bot h ways you end up wit h roughly
t he same amount .

I t doesn’t mat t er if t he fut ure spot rat e falls below $1. 56/ €, because by
using t he money market you ar e guarant eed $1, 563, 134.

Ex ampl e 1
The Boeing U. S Corporat ion export ed a Boeing 747 t o Aust ralia. The aircraft was
sold for $AUS8 million. The current spot rat e in U. S t erms is $US1. 30/ $AUS.
The 1 year forward exchange rat e is $US1. 25/ $AUS. The current int erest rat es
in t he U. S and Aust ralia are 5% and 9% respect ively. How can Boeing hedge
against t he risk of falling exchange rat es by using t he money market ? What is
t he amount t hey will receive in 1 year and what will be gain or loss incurred for
using t he money market :

a. The spot rat e in 1 year t urns out t o be $US1. 19/ AUS$
b. The spot rat e in 1 year t urns out t o be $US1. 36/ AUS$


1. Borrow t he pr esent val ue of t he foreign currency.

I n order t o det ermine t he present value of €1 million we discount it by t he
current foreign int erest rat e.

Pv =
$A0S 8,uuu,uuu
1.u9
= $A0S 7,SS9,449.Su

2. Convert t he amount borrowed int o domest ic currency at t he current spot
rat e.
$0S 1.Su × $A0S 7,SS9,449.Su = $0S $9,S41,284.4u

3. I nvest t he $US 9, 541, 284. 40 in t he Unit ed St at es

4. I n 1 year’s t ime receive t he €1 million and repay t he loan.

5. Receive t he 1 year mat urit y value of t he amount invest ed in t he Unit ed
St at es.
$0S 9,S41,284.4 × 1.uS = $0S 1u,u18,S48.6u

Aft er 1 year Boeing will receive $US10, 018, 348. 60

a. I f Boeing did not use t he money market t o hedge against t he risk of
falling exchange rat es and t he spot rat e fall t o $1. 19/ AUS t hey would
have received $9, 520, 000. By using t he money market t o hedge t heir
risk t hey have saved $498, 348. 60 ( $10, 018, 348. 60 - $9, 520, 000) .

b. I f t he spot rat e in 1 year t urns out t o be $US1. 32/ $AUS t hen Boeing could
have pot ent ial received $10, 880, 000, t hus missing out on $861, 651. 40
( $10, 018, 348. 60 - $10, 880, 000) .

Remember , t he poi nt of hedgi ng i s not t o max i mi se pr of i t s, but
r at her i t i s t o r educe l oss.

Ex change Rat es – Money Mar k et Hedge

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Money Mar k et Pay abl es Hedge

A large U. S. manufact uring company import s engines for t heir mining
machinery. Each piece of engine cost s €500, 000 and is payable in 1 year .

 U. S. int er est rat e is 6%
 Germany int erest rat e is 6. 7%
 Spot exchange rat e is $1. 60/ €
 1 year forward exchange rat e is $1. 55/ €

I n order t o hedge against foreign exchange rat e r isk you need t o:

The company will want t o borrow from t he count ry wit h t he lowest
int erest rat e and invest in t he count ry wit h t he highest int erest rat e.
Therefore t hey will choose t o borrow domest ically from U. S and invest
int ernat ionally in Ger many.

1. Det ermine t he pr esent val ue of t he f or ei gn cur r ency .

I n order t o det er mine t he present value of €500, 000 we discount it
by t he current foreign int er est rat e.

Pv =
€Suu,uuu
1.u67
= €468,6u4

2. I nvest t he present value of €500, 000, ( €468, 604) in t he Ger many
int erest rat e at 6. 7%. Upon mat ur it y t hey will receive €500, 000 t o
repay t he account .

3. They will need t o invest t he €468, 604 in t he U. S market . Conver t
t his amount int o U. S. dollars at t he current spot rat e t o det ermine
t he amount needed t o be borrowed domest ically.

€468,6u4 × $1.6u = $749,766

4. Det ermine t he f ut ur e v al ue of t he loan t hat must be repaid.

$749,766 × $1.u6 = $794,7S2

5. This should be enough t o repay t he €500, 000 loan in 1 year. We
can check my conver t ing it back int o t he Euros at t he expect ed 1
year fut ure spot rat e.

$794,7S2 ×
1
1.SS
= €S12,74S


Ex change Rat es – Money Mar k et Hedge

© 2010 ht t p: / / w w w .w eal l st ar t somew her e.com
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Ex ampl e 2
The Boeing U. S. Corporat ion import s engine j et s for it s Boeings 747 aircraft s.
The j et engine cost s €400, 000, is import ed from Germany, and is payable in 1
year. The current spot rat e in U.S. t erms is $US1. 34/ €. The 1 year forward
exchange rat e is $US 1. 25/ €. The current int erest rat es in t he Aust ralia and
Germany are 5% and 9% respect ively. How can Boeing hedge against t he risk of
falling exchange rat es by using t he money market ? What is t he amount t hey will
receive in 1 year and what will be gain or loss incurred for using t he money
market :

Aust ralia has t he lowest int erest rat es so Boeing will want t o bor r ow
domest i cal l y and i nvest i nt er nat i onal l y in t he German market .

1. Det ermine t he pr esent val ue of t he f or ei gn cur r ency.

I n order t o det ermine t he present value of €400, 000 we discount it by t he
current foreign int erest rat e.

Pv =
€4uu,uuu
1.u9
= €S66,972

2. I nvest t he present value of €400, 000, ( €366, 972) in t he Germany int erest
rat e at 9%. Upon mat urit y t hey will receive €400, 000 t o repay t he
account .

3. They will need t o invest t his €366,972 in t he U. S market . Convert t his
amount int o U. S. dollars at t he current spot rat e t o det ermine t he amount
needed t o be borrowed domest ically.

€S66,972 × $1.S4 = $491,74S

4. Det ermine t he f ut ur e v al ue of t he loan t hat must be repaid.

$491,74S × $1.uS = $S16,SSu

5. This should be enough t o repay t he €500, 000 loan in 1 year. We can
check by convert ing it back int o t he Euros at t he expect ed 1 year fut ure
spot rat e.

$S16,SSu ×
1
1.2S
= €41S,u64

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