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 U.S. 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 determine the cost of implementing the hedge, we need to calculate the expected future value of the payable in euros using both the investment and borrowing options.

Investment option: 
FV = 1,000,000 euros x (1 + 0.05/365)^30 
FV = 1,001,643 euros

Borrowing option: 
PV = 1,000,000 euros / 1.00 = $1,000,000 
FV = $1,000,000 x (1 + 0.06/365)^30 
FV = $1,001,431 
FV = €1,001,431 / 1.00 = 1,001,431 euros

Therefore, the cost of implementing the hedge is the difference between the expected future value of the payable using the investment option and the borrowing option: 
Cost = 1,001,643 euros - 1,001,431 euros 
Cost = 212 euros

To convert the cost to U.S. dollars, we use the spot exchange rate: 
Cost = 212 euros x $1.00/euro 
Cost = $212

Therefore, the cost of implementing the hedge is $212, which is closest to option C ($1,000,830).

Blake Inc Needs €1,000,000 in 30 Days