A China's company will receive5,000,000 USD in one year. Assume that one-year Chinese interest rate is 4% and one-year American interest rate is 6%, spot rate of USD is 7.0 ¥ and one-year forward rate of USD is 6.8 ¥. Would it be better-off using a forward hedge or a money market hedge? Substantiate your answer with estimated revenue for each type of hedge.

Option-1:Forward Hedge:-

Foreign Currency to be received after 1 year= USD 5,000,000

1 year forward rate : 1USD = ¥ 6.80

Under forward hedge , the Chinese Company will enter into a forward contract to sell USD 5,000,000 @ ¥ 6.80 per USD.

Hence total revenue under Forward hedge or Amount to be received under Forward hedge = Foreign Currency to be received after 1 year * 1 year forward rate

=>Total revenue under Forward hedge= USD 5,000,000 *  ¥ 6.80 Per USD

=>Total revenue under Forward hedge= ¥ 34,000,000

Option-2:Money Market  Hedge:-

Foreign Currency to be received after 1 year= USD 5,000,000

Spot rate : 1USD = ¥ 7

1 year Chinese Interest rate = 4%

1 year American interest rate = 6%

Step:-1

Under Money market hedge, the Chinese company first Borrow such amount of Foreign currency, such that the foreign currency borrowing along with interest on it will be fully repaid by the Foreign currency receivable.

Hence Foreign currency or USD to be borrowed now= Foreign Currency to be received / (1+ Foreign currency interest rate * Number of period)

=>USD to be borrowed now= USD 5,000,000 / (1+6% *1 yr)

=>USD to be borrowed now=USD 5,000,000 / (1+0.06)

=>USD to be borrowed now=USD 5,000,000 /1.06 = 4,716,981.13 USD

Step:-2

Now the after borrowing the USD the Chinese company should convert the USD to ¥ at spot rate.

¥ to be received by converion of USD borrowed = 4,716,981.13 USD * ¥ 7 per USD

=>¥ to be received by converion of USD borrowed = ¥ 33,018,867.92

Step:-3

Now the  Chinese company will invest the ¥ 33,018,867.92 received at 4% interest rate for 1 years.

Step:-4

After 1 year ¥ to be received= ¥ invested + interest on ¥ invested

=>After 1 year ¥ to be received=¥ 33,018,867.92+ [ ¥ 33,018,867.92 * 4%]

=>After 1 year ¥ to be received= ¥ 33,018,867.92 + ¥ 1,320,754.72

=>After 1 year ¥ to be received=  ¥ 34,339,622.64

Step:-5

USD 5,000,000 to be received after 1 year will be fully used to repay the USD loan taken at step 1.

Because USD loan to be repaid after 1 year along with interest = 4,716,981.13 USD + [ 4,716,981.13 USD * 6%]=USD 5,000,000.

Hence total receipt or Revenue under Money market hedge =¥ 34,339,622.64

As the receipt or revenue under Money Market hedge is more than the Forward merket hedge , hence the Company should use Money Market hedge. [ Answer]