Wenden Co is a Dutch-based company which has the following expected transactions.

One month: Expected receipt of            £2,40,000

One month: Expected payment of                                                                  £1,40,000 Three months: Expected receipts of                                                                  £3,00,000

The finance manager has collected the following information: Spot rate (£ per €):             1.7820 ± 0.0002 One month forward rate (£ per €): 1.7829 ± 0.0003 Three months forward rate (£ per €):                                                                  1.7846 ± 0.0004 Money market rates for Wenden Co:

Borrowing       Deposit

One year Euro interest rate:                   4.9%                    4.6

One year Sterling interest rate:              5.4%                    5.1

Assume that it is now 1 April.

Required:

• Calculate the expected Euro receipts in one month and in three months using the forward market.
• Calculate the expected Euro receipts in three months using a money- market hedge and recommend whether a forward market hedge or a money market hedge should be used.

Solution

• Forward market evaluation

Net receipt in 1 month = £2,40,000 – £1,40,000                       = £1,00,000 Wenden Co needs to sell Sterlings at an exchange rate of (1.7829 + 0.0003)

=£1.7832per €

Euro value of net receipt = 1,00,000/ 1.7832                              =€56,079

Receipt in 3 months                                                                     = £3,00,000

Wenden  Co needs to sell Sterlings at an exchange rate of 1.7846 + 0.0004

=£1.7850per €

Euro value of receipt in 3 months = 3,00,000/ 1.7850                =€1,68,067

• Evaluation of money-market hedge (Borrow – Sell – Invest)

Expected receipt after 3 months                                                  = £300,000 Step 1 : Borrow

Sterling interest rate over three months = 5.4/ 4                         = 1.35%

Sterlings to borrow now to have £300,000 liability

after 3 months = 300,000/ 1.0135                                              = £296,004 Step 2 : Sell

Spot rate for selling Sterling = 1.7820 + 0.0002                          = £1.7822 per€ Euro deposit from borrowed Sterling at spot = 296,004/ 1.7822                                                                                         = €166,089 Step 3 : Invest

Euro interest rate over three months = 4.6/ 4                             = 1.15% Value in 3 months of Euro deposit = 166,089 x 1.0115        = €167,999

The forward market is marginally preferable to the money market hedge for the Sterling receipt expected after 3 months.

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