If the spot rate for Euro is .91 Euro is equal to 1 US $, and the annual interes

Question

If the spot rate for Euro is .91 Euro is equal to 1 US $, and the annual interest rate on fixed rate one-year deposits of Euro is 3.5% and for US$ is 2.5%, what is the nine-month forward rate for one Euro in terms of dollars? Assuming the same interest rates, what is the 18-month forward rate for one dollar in Euros? Is this an indirect or a direct rate? If the forward rate is an accurate predictor of exchange rates, will the Euro get stronger or weaker against the dollar? What does this indicate about the market’s inflation expectations in the Euro-zone compared to the US? On January 2d, 2016, Microsoft is shipping 1,500,000 new X-Boxes from its US plant, which it will sell through EU dealers on 270-day terms at 350 Euro each. So Microsoft will receive payment from its dealers on September 28th, 2016. Assuming that Microsoft needs to cover its expenses in the US and thus wants to hedge its Euro/US$ exposure using a forward contract with a US bank, what is the minimum amount of US dollars they should receive on September 28th, 2016 given the 9-month forward rate for one Euro in terms of US dollars that you calculated in problem one? What are two other ways Microsoft could hedge their Euro/US$ exposure?

Explanation / Answer

1) The given rate is a direct rate for $ in terms of euro; euro being the home currency and $ the foreign currency.

2) The forward rate according to the Interest rate parity theory (IRPT) = Spot rate * (1+Rh)(1+Rf)

Here we require the forward rate for euro against the $; the spot rate then becomes 1/0.91 = 1.0989$/euro

The 9m future rate for euro in terms of $ will be 1.0989(1+0.025*.75)/(1+0.035*0.75) = 1.1195/1.02625 = 1.0909

The nine month rate for euro in terms of $ is 1.0909$/euro

3) The 18 months forward rate for $ in terms of euro = 0.91(1+0.035*1.5)/(1+0.025*1.5) = 0.9578/1.0188 = 0.9401

The forward rate as per IRPT for 1 $ in terms of euro = 0.9401euro/$.

This is a direct rate for $ and indirect rate for euro.

4) As interest rates in euro is higher than the interest rates in $, there would be expectation of higher inflation rates in euro than in $.

5) Total sale value = 1.5m*350 = euro 525 millions.

The minimum amount that should be received in terms of $ = 525*1.0909 = 575.7225 million euros.

6) Other 2 ways are

a) money market hedge

b) selling futures in euros.

Related Questions

Navigate

• Browse (All)
• Browse I
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.