contracts more common than forward contracts? Question: Managing Foreign Exchang
ID: 1172619 • Letter: C
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contracts more common than forward contracts? Question: Managing Foreign Exchange Exposure Springfield Manufacturing Ltd, a client to whom you provide financial advice has come to you for guidance over a foreign exchange transaction. The company based in New Zealand has sold USD parts to a USA customer. The payment has been deferred for six months. The following information is relevant: Spot exchange rate Six month forward rate Company's cost of capital US - deposit rate US- lending rate New Zealand - lending rate New Zealand - deposit rate Risk free rate in New Zealand Risk free rate in the USA 1.4493/USD 1.4354/USD 12.0% ?.?. 6.0% p.a. 7.0% ?.?. 6.0% ?.?. 5.0% pa. 20% pa. 4.0% pa. Required: a) Calculate the expected spot rate in 6 months assuming that the interest rate parity between b) Calculate the expected value of the sales proceeds in NZD using the expected spot rate c) Calculate and value of the proceed d) Explain and calculate the net proceeds receivable by Springfield Manufacturing Ltd if money e) Based on your calculations above, which alternative would you recommend and why? the two countries holds. computed in (a) above. agreement market hedge is used. s from the sale if the company enters into a forward rate (Show workings)Explanation / Answer
a. Expected Spot Rate
Under the covered interest rate parity, the following formula must hold true
(1 + id) = (S / F) * (1 + if)
Where:
id is the interest rate in the domestic currency, or the base currency
if is the interest rate in the foreign currency, or the quoted currency
S is the current spot foreign exchange rate
F is the forward foreign exchange rate
(1+0.01) = (S/1.4354) * (1 + 0.02)
1.01 = 1.02*S / 1.4354
(1.01 * 1.4354) / 1.02 = S
S = 1.4213
b. Expected Value of Sale Proceeds
= 2000000 * 1.4213
= 2842400 New Zealand dollar
c. If Company enters into Forward Rate Agreement
Given forward rate 1.4354/USD
Expected Proceeds = 2000000 * 1.4354
= 2870800 New Zealand Dollar
d. Money Market Hedge
If a foreign currency receivable is expected after a defined period of time and currency risk is desired to be hedged via the money market, this would necessitate the following steps:
Accordingly,
e. Amongst all the three alternatives, we would recommend Forward Rate Agreement to the New Zealand Company as it gives comparatively higher expected proceeds that is New Zealand Dollar 2870800
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