Blake Inc. needs €1,000,000 in 30 days. It can earn 5 percent annualized on a German security. The current spot rate for the euro is $1.00. Blake can borrow funds in the United States at an annualized interest rate of 6 percent. If Blake uses a money market hedge to hedge the payable, what is the cost of implementing the hedge?

Question

Quizplus · Accepted Answer

To calculate the cost of implementing the hedge, we need to compare the cost of borrowing in the US and the return from investing in the German security.

If Blake doesn't hedge, it can borrow $1,000,000 in the US at an interest rate of 6% per year, which works out to be $15,068.49 in interest over a 30-day period.

However, if Blake decides to hedge using a money market hedge, it would need to do the following:

1. Borrow $1,000,830 in the US to have enough funds to convert to euros at the current spot rate of $1.00 for €1.00.
2. Convert $1,000,830 to €1,000,830 at the spot rate of $1.00 for €1.00.
3. Invest €1,000,830 in the German security at a rate of 5% per year, which would earn €4,122.11 in interest over a 30-day period.
4. At the end of the 30-day period, convert €1,004,122.11 back to US dollars at the spot rate prevailing at that time.
5. Pay back the $1,000,830 borrowed in the US plus interest of $15,068.49.

Assuming the spot rate doesn't change, the cost of implementing the hedge would be the interest paid on the US loan minus the interest earned on the German security plus any transaction costs involved in the conversion of currencies.

Therefore, the cost of implementing the hedge would be $15,068.49 - €4,122.11 = $10,946.38, which is equivalent to €1,000,830.

Blake Inc Needs €1,000,000 in 30 Days