Hedging Dozier Industries
Forward Market Hedge:
Dozier would purchase U.S. dollars under a forward contract. The contract would obligate Dozier to pay £1,057,500 in exchange for £1,057,500 x 1.4198 $/£ = $1,501,438.50 assuming the transaction was at the quoted 3-month forward rate in Exhibit 4.
Relative to the value of the contract at the current exchange rate, £1,057,500 x 1.4370 $/£ = $1,519,627.50
Dozier would accepting a reduction in the revenue from the contract of $1,519,627.50 - $1,501,438.50 = $18,198.00 or $18,198 / $1,519,627.50 = 1.20%
Money Market Hedge:
In this case, Dozier would borrow an amount of British pounds that would obligate Dozier to a principal and interest payment in three months that …show more content…
If you want to assure yourself that the formulas are correct, set up the calculations we did before algebraically and see how the currency numbers cancel out.
The main problem with these formulas is keeping track of which interest rate goes where. There is a handy rule for this. Take the exchange rate quote that you are using, here $/£. Think of this in general as X/Y. So, the money market formula is, in general, (X interest rate – Y interest rate) / (1. + Y interest rate) or, in shorthand, (X – Y) /(1 + Y)
So if you were using a yen/dollar quote for the exchange rate, you would have yen rate minus dollar rate divided by one plus dollar rate.
Note that none of this really solves Dozier's problem; but there is a theory that in well functioning markets, the results from the two formulas should be equal. In other words, it shouldn't make a difference whether you hedge in the forward market or in the money market. However this theory is based on comparing apples to apples. Here the apples are the financial instruments whose interest rates we are comparing. Our interest rate calculation is based on the cost of a UK bank loan to Dozier compared to rate on a bank CD. The theory works a bit better if you use the Eurodollar rate and the Europound rate in