Dow Chemical is to deliver chemicals to an Indian firm in one year and is suppos

Question

Dow Chemical is to deliver chemicals to an Indian firm in one year and is supposed to receive 40 million rupee (INR) at the time of delivery. The current exchange rate is 34.5 rupee per dollar (INR/$) and the one year-forward rate is 40 rupee per dollar (INR/$). Dow’s one-year interest rates are 18% for rupee funds and 4% for dollar funds.

Suppose that Dow decides to hedge its exposure to the rupee. What are the alternatives available to Dow based on the information given? Which hedge is optimal for Dow?

Explanation / Answer

Dow can Hedge using 1)Forward contract 2 )money market contract

1)Forward contract :Amount expected to collect under this option= Amount in INR /forward rate

                  = 40/40

                  = $ 1 million

2)Money market hedge :

Since DOw has asset created in Indian currency ,He should borrow today amount that will worth equal to 40 million In INR after one year

Amount borrowed in INR today = 40,000,000/1.18 = 33,898,305.0847

NOw,Invest this money in US by converting it to dollar using current exchange rate

Dollars by conversion = 33,898,305.0847/34.5

       = $ 982,559.5677 (invest it for one year at 4%)

Amount received after one year 982,559.5677 (1+.04) = 1,021,861.9504

Since the amount received under money market hedge is higher than in forward cover,Money market hedge should be used.

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