Suppose General Motors uses a money market hedge to protect an Lit 200 million payable due in one year. The U.S. interest rate at the time of the hedge was 9% and the lira interest rate was 14%. If the spot rate moved from Lit 1293 at the start of the year to Lit 1349 at the end of the year, what was GM's cost of the money market hedge?

Question

Quizplus · Accepted Answer

To use a money market hedge, GM would have borrowed Lit 200 million at the lira interest rate of 14% and invested the borrowed amount in the U.S. money market at the interest rate of 9%. GM would have received Lit 200 million * 14% = Lit 28 million in interest from the lira investment and would have paid Lit 200 million * 9% = Lit 18 million in interest on the U.S. investment, resulting in a net gain of Lit 10 million. 
Using the spot rates at the start and end of the year, we can calculate the cost of the hedge as follows: 
Lit 200 million / 1293 = $154,518
Lit 200 million / 1349 = $148,242
The cost of the hedge is the difference between the two amounts, or $148,242 - $154,518 = -$6,276. However, since the net gain from interest was Lit 10 million, which is approximately $7,796 at the exchange rate of Lit 1,293/USD, GM's overall gain was $7,796 - $6,276 = $1,520. Therefore, the correct answer is B.

Suppose General Motors Uses a Money Market Hedge to Protect