Dozier Hedging Alternatives
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 ...view middle of the document...
50 - $1,493,995.23 = $25,632.27 or
$25,632.27 / $1,519,627.50 = 1.69%
That is a bigger reduction in the value of the contract than the forward market hedge. So if that is Dozier's use of funds, the company would be better off using the forward market.
On the other hand, they were borrowing under a credit line at the end of the year at an interest rate of 10.5% (prime + 1%). If they avoid borrowing at least as much as the UK borrowing would provide over the next three months, the company might be better off with the UK loan than it would with the forward rate contract. Here the choice also depends on whether they can actually borrow at a fixed rate of interest for three months and other considerations including accounting issues.
We could calculate a “breakeven” interest rate—the average USD rate that must apply to the dollars received from UK borrowing for Dozier to be indifferent between the two hedging methods.
$1,464,701.21 x (1 + i) = $1,501,438.50
(1 + i) = $1,501,438.50/$1,464,701.21 = 1.02508
which is an annual rate of 10.03%. If having cash in the US is worth more than 10%, UK borrowing would be a better hedging method.
It's a bit of a pain to do these calculations. Fortunately there is a shortcut. First, for the forward hedge, the following formula can be used:
Cost of forward hedge = (Forward – Spot) / Spot
= (1.4198 – 1.4370) / 1.4370
= –0.0120 or –1.20 %
The negative number shows that it is a "cost". If the result is positive, you are "benefiting" from the hedge relative to the value of the contract at current spot exchange rate.
For the money market hedge, the shortcut formula is:
Cost of MM hedge = ($ interest rate – £ interest rate) / (1. + £ interest rate)
= (0.02 – 0.0375) / (1.0375)
= –0.0169 or – 1.69%
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,