Air France KLM has just signed a contract to purchase a Boeing 737 aircraft. Air

Question

Air France KLM has just signed a contract to purchase a Boeing 737 aircraft. Air France KLM will be billed USD20 million which is payable in 180 days. The current spot exchange rate is USD1.2000/EUR and its bank Credit Lyonnaise quotes a 180-day forward rate of USD1.2010/EUR. The 180-day interest rate is 2.5% pa. in the US. and 1.0% in France. Air France KLM is concerned with the volatile exchange rate between the dollar and the euro and would like to hedge the FX exposure. a It is considering two hedging alternatives: a forward contract or a money market hedge. Which alternative would you recommend? Why? b Other things being equal, at what annualised EUR interest rate would Air France KLM be indifferent between the two hedging methods?

Explanation / Answer

a) Two hedging alternatives - forward contract or a money market hedge.

For Air France KLM ----

Home Currency = EUR

Foreign Currency = USD ($)

Let us consider one by one as under to derive at a conclusion.

1. Forward Contract

** Note - 20,000,000 / 1.2010

2. Money market hedge

In the following steps we will identify the liability (currency payable) and assets (currency available) and then borrow currency to the extent of present value of currency payable. Then we convert currency payable at spot rate and invest into home currency (here it is in France (Eur)) and finally settle the amount payable.

IDENTIFY : USD ($) Liability (currency payable)

CREATE : USD ($) Assets

BORROW : Borrow EUR (home currency) to the extent of present value (PV) of foreign currency payable (USD $)

PV USD 20,000,000 @ 2.50% for 180 days

= 20,000,000/(1+1.25%)* (*Note - period is of 180 days means semi-annually so rate of interest is half of 2.50%)

= 20,000,000/(1 + 0.0125)

= 20,000,000/1.0125

= USD ($) 19,753,086.42

CONVERT : Sell 'x', EUR borrow and convert into USD ($) at Spot Rate (here, Spot Rate for EUR is relevant = USD1.2000/EUR)

1 EUR = USD ($) 1.2000

? EUR = USD ($) 19,753,086.42

Therefore, USD ($) 19,753,086.42 / USD ($) 1.2000

= 16,460,905.35 EUR

INVEST : Invest 16,460,905.35 EUR @ 1.0% (in Home Country - France) for 180 days

Amount received by investing at the end of 180 days will be -

= 16,460,905.35 EUR x (1 + 0.05%)* (*Note - Interest rate is calculated semi-annually so, 1/2 x 1.0% = 0.05%)

= 16,460,905.35 EUR x (1 + 0.005)

= 16,460,905.35 EUR x 1.005

= 16543209.88 EUR

SETTLE : On the duedate of maturity proceeds are used to settle USD ($) liability (amount payable) of USD ($) 20 million.

Analysis :

From the two alternatives following are amounts payable

RECOMMENDATION :

Money market hedge alternative is recommended as the liability (amount payable) is less as compared to forward contract. (Refer above table for amounts)

b) Using Interest Rate Parity formula we can derive annualised EUR interest rate be indifferent between the two hedging methods as under -

Formula -

Forward Rate = Spot Rate x [1 + Interest rate of foreign country (USD ($))] / [1+ Interest rate of home country (EUR)

We have to find annualised EUR interest rate so lets assume it as "x"

1.2010 = 1.2000 x [(1 + 2.5%) / (1 + x%)]

1.2010 = 1.2000 x [(1 + 0.025) / (1 + x%)]

1.2010 / 1.2000 = [(1 + 0.025) / (1 + x%)]

1.0008 = (1 + 0.025) / (1 + x%)

(1 + x%) = (1 + 0.025) / 1.0008

1 + x% = 1.025 / 1.0008

1 + x% = 1.0241

x% = 1.0241 - 1

x% = 0.0241

x% = 0.0241 * 100

x% = 2.41%

Other things being equal, at 2.41% Annualised EUR interest rate would Air France KLM be indifferent between the two hedging methods.

Particulars Amount A Amount payable USD 20 million B 180 days forward rate USD1.2010/EUR C Total amount payable (A/B) (in EUR)**Note 16,652,789.34

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