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How does the credit or money market hedge work?

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2007-11-10 19:00:37

Money Market Hedge

is an internal hedging technique. As a scenario, imagine a UK

company with a 1 year receivable of $1,000,000. If the Spot FX rate

is 2.000 and US interest rates were 4% and UK interest rates were

5%. The company would borrow $1,000,000 discounted by 4%

($1,000,000/1.04) = $961,538.46, then convert it into Sterling at

2.000 = £480,769.23. The Sterling would then be placed on deposit

at 5% (£480,769.23*1.05 = £504,807.69). In one year's time the

company receives the expected $1,000,000 and repays the $ loan in

full. Therefore the company has hedged the foreign exposure and has

enjoyed the Sterling equivalent for the full period. The

calculation for the effective Foreign Exchange Forward Outright is

$1,000,000/£504,807.69 = 1.98. Forward Outright formula -

[Spot-(((1+ih)/(1+if)-1)*Spot)] or [2-(((1.05)/(1.04))-1)*2]

Spot=Current FX rate

ih=Interest in Home

country if=Interest in

foreign country JustinPC-10-11-07


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