Money market hedge o This is the same idea as covered interest arbitrage McGraw-Hilylrwoin 13-5 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-5 Money Market Hedge ⚫ This is the same idea as covered interest arbitrage
Money market hedge The importer of British woolens can hedge his i100 million payable with a money market hedge Borrow s112.05 million in the U.S Translate $112.05 million into pounds at the spot rate S(S/f) $1.25/￡ Invest t89.64 million in the UK at i t=11. 56%for one year In one year your investment will have grown to f100 million Spot exchange rate S($/f) $1.25/￡ 360-day forward rate o($/f)|=$120/￡ 360 U.S. discount rate 7.10 British discount rate 11.56% McGraw-Hilylrwoin 13-6 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-6 Money Market Hedge The importer of British woolens can hedge his £100 million payable with a money market hedge: Borrow $112.05 million in the U.S. Translate $112.05 million into pounds at the spot rate S($/£) = $1.25/£ Invest £89.64 million in the UK at i£= 11.56% for one year. In one year your investment will have grown to £100 million. Spot exchange rate S($/£) = $1.25/£ 360-day forward rate F360($/£) = $1.20/£ U.S. discount rate i$ = 7.10% British discount rate i£ = 11.56%
Money market hedge Where do the numbers come from? We owe our supplier f100 million in one year-so we know that we need to have an investment with a future value of f100 million Since i 11.56%we need to invest f89.64 million at the start of the year ?00 ?964= 1.1156 How many dollars will it take to acquire f89.64 million at the start of the year if the spot rate s($/f)=$1.25/f? $1.00 $11205=?964× ?25 McGraw-Hilylrwoin 13-7 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-7 Money Market Hedge Where do the numbers come from? We owe our supplier £100 million in one year—so we know that we need to have an investment with a future value of £100 million. Since i£= 11.56% we need to invest £89.64 million at the start of the year. How many dollars will it take to acquire £89.64 million at the start of the year if the spot rate S($/£) = $1.25/£? 1.1156 ?00 ?9.64 = ?.25 $1.00 $112.05 = ?9.64
Money market hedge Suppose you want to hedge a payable in the amount of￡ y with a maturity of i. Borrow Sx at t=0 on a loan at a rate of is per year (Note that Sx= fy(1+ie)at the spot rate. ii. Exchange Sx for Ey/(1+ ie)at the prevailing spot rate invest ty/(1+itat if for the maturity of the payable to achieve￡y At maturity, you will owe a sx(1 + is) Your British investments will have grown enough to service your payable and you will have no exposure to the pound McGraw-Hilylrwoin 13-8 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-8 Money Market Hedge Suppose you want to hedge a payable in the amount of £y with a maturity of T: i. Borrow $x at t = 0 on a loan at a rate of i$ per year. (Note that $x = £y/(1+ i£) T at the spot rate.) ii. Exchange $x for £y/(1+ i£) T at the prevailing spot rate, invest £y/(1+ i£) T at i£for the maturity of the payable to achieve £y. At maturity, you will owe a $x(1 + i$ ). Your British investments will have grown enough to service your payable and you will have no exposure to the pound
Money market hedge Suppose you want to hedge a f receivable in the amount of fy with a maturity of t' . Borrow fy(1+ie)at t=0 ii. Exchange Ey/(1+ie) for Sx at the prevailing spot rate At maturity, you will owe a Sy which can be paid with your receivable You will have no exposure to the dollar-pound exchange rate McGraw-Hilylrwoin 13-9 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-9 Money Market Hedge Suppose you want to hedge a £ receivable in the amount of £y with a maturity of T: i. Borrow £y/(1+ i£) T at t = 0. ii. Exchange £y/(1+ i£) T for $x at the prevailing spot rate. At maturity, you will owe a $y which can be paid with your receivable. You will have no exposure to the dollar-pound exchange rate