Money Market Hedges - payment 5 / 13

Money Market Hedges - payment

The whole idea of a money market hedge is to take the exchange rate NOW even though the payment is in the future.

By doing this we eliminate the future exchange risk (and possible benefits too of course)

So. the foreign payment is in the future, but we are going to get some foreign currency NOW to pay for it.

We do not need the full amount though, as we can put the foreign money into a foreign deposit account to earn just enough interest to make the full payment when ready

We, therefore, calculate how much is needed now by taking the full amount and discounting it down at the foreign deposit rate

Now we know how much foreign currency we need NOW, we can convert that into home currency using the spot rate

We now know how much home currency we need. This needs to be borrowed. So, the cost to us will eventually be:

  • Amount of home currency borrowed + interest on that until payment is made. 

    (Obviously here we use the home borrowing rate)

Steps:

  1. Calculate how much foreign currency needed (discount @ foreign deposit rate)

  2. Convert that to home currency

  3. Borrow that amount of home currency

  4. The cost will be the amount borrowed plus interest on that (home currency borrowing rate)

Illustration

Let’s say we are a UK company and need to pay $100 in 1 year. 

UK borrowing rate is 8% and US deposit rate is 10%. 

Exchange rate now $2 - 2.2 :£

  • Need to pay $100 in 1 year so we borrow 100 x 1/ 1.10 = 91

  • Borrow just $91 as we then put it on deposit and it attracts 10% interest - to pay off the whole $100 at the end

  • Convert $91 dollars now. We need dollars, so bank SELLS us them. They always SELL LOW. So 91 / 2 = £45.5

  • £45.5 is borrowed now. We will then have to pay interest on this in the UK for a year. 

    So £45.5 x 1.08 = 49.14

    £49.14 is the total cost to us

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