Purchase Solution

# Hedging using forward market and money market hedges

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You are negotiating the purchase of textile machinery either from a German supplier or a Japanese supplier. The German supplier is prepared to sell you fully automated looms at a price of 20,000 Euros per loom. Payment will be made in Euros at the time of delivery, which is promised for one month hence. The Japanese supplier would deliver identical looms in one month but would accept payment in dollars in the amount of \$ 10,000 per loom and would defer the payment for 11 months after the delivery of the looms. You like the Japanese proposal because it eliminates exchange risk and extends substantial trade credit, but you wonder if German offer wouldn't be superior if you hedged the exchange risk. Your bank supplies you with the following exchange rate data:

Spot exchange rate \$.45/Euro Y 125/ \$
1 month forward \$.46/Euro Y 127/ \$
12 month forward \$.50/Euro Y 130/ \$

The bank also indicates it will lend you dollars for a period from 1 to 12 months at an annual rate of 12%. It will lend you euros for a similar time period at 8% per annum and yen at 4% per annum. Assume that you can also invest at the same rates.

i) Consider hedging the euro payment in the forward market and identify the present value today of the cost in dollars under the forward hedge.

ii) Consider hedging the euro payment in the money market. Clearly identify the various steps and amount of dollars needed today for the spot hedge.

iii) To hedge the euro payment what must be your US dollar opportunity cost for you to be indifferent between a forward market hedge and a money market hedge?

iv) Find the cost of the Japanese loom and make your recommendations regarding a Japanese or German supplier.

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The solution answers questions on hedging using forward market and money market hedges.

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Price Payment due
German supplier 20,000 Euro 1 month from now
Japanese supplier \$10,000 12 month from now

Spot exchange rate \$.45/Euro Y 125/ \$
1 month forward \$.46/Euro Y 127/ \$
12 month forward \$.50/Euro Y 130/ \$

Bank interest rate

Dollar 12% per annum
Euro 8% per annum
Yen 4% per annum

i) Hedging the euro payment in the forward market

1 month forward \$.46/Euro

20,000 Euro will cost \$9,200

Present value of \$9,200 will be obtained by discounting this payment by the dollar interest ...

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