Hanson Corp. frequently uses a forward hedge to hedge its British pound (£) payables. For the next quarter, Hanson has identified its net exposure to the pound as being £1,000,000. The 90-day forward rate is $1.50. Furthermore, Hanson's financial center has indicated that the predicted value of the British pound at the end of the next quarter is $1.57. Based on this information, what is the expected real cost of hedging payables?
A) $70,000
B) -$70,000
C) $0
D) $1,570,000

Question

Quizplus · Accepted Answer

To calculate the expected real cost of hedging payables, we need to compare the cost of using the forward hedge with the cost of not using the hedge (i.e., the cost of paying the payables at the spot rate at the end of the next quarter).
If Hanson uses the forward hedge, it would pay $1,500,000 (= £1,000,000 x $1.50/£) in 90 days to settle the payables. If it does not use the hedge, it would pay $1,570,000 (= £1,000,000 x $1.57/£) in 90 days to settle the payables.
Therefore, the cost of using the hedge is:
Cost of using the hedge = $1,500,000 - $1,570,000 = -$70,000
The negative sign indicates that using the hedge results in cost savings for Hanson.