Dozier Hedging Alternatives

Forward Market Hedge: Dozier would purchase U.S. dollars under a forward contract. The contract would obligate Dozier to pay 1,057,500 in exchange for 1,057,500 x 1.4198 $/ = $1,501,438.50 assuming the transaction was at the quoted 3-month forward rate in Exhibit 4. Relative to the value of the contract at the current exchange rate, 1,057,500 x 1.4370 $/ = $1,519,627.50 Dozier would accepting a reduction in the revenue from the contract of $1,519,627.50 - $1,501,438.50 = $18,198.00 $18,198 / $1,519,627.50 = 1.20% Money Market Hedge: In this case, Dozier would borrow an amount of British pounds that would obligate Dozier to a principal and interest payment in three months that would exactly equal the amount that Dozier expects to receive. At an interest rate of 15% per year (3.75% for three months, the amount to borrow equals 1,057,500 / (1.0375) = 1,019,277.11 Dozier would immediately exchange the pounds into dollars at the current exchange rate. So Dozier would have 1,019,277.11 x 1.4370 $/ = $1,464,701.21 The problem with this alternative is that we have dollars today (if you want to consider that a problem) and we need to compare the results with the forward hedge which gives us dollar three months from now. So, we need a way to compare dollars today with dollars in three months; i.e., we need an interest rate. So we ask, what can Dozier do with dollars today? Well they could invest the money in a safe investment, providing an 8.0% annual interest rate. If we assume that the company's opportunity cost of funds is investment at 8.0% (2% for three months), we can calculate how much money they would have in three months time. $1,464,701.21 x (1.02) = $1,493,995.23 Relative to the value of the contract at the current exchange rate, 1,057,500 x 1.4370 $/ = $1,519,627.50 Dozier would accepting a reduction in the revenue from the contract of $1,519,627.50 - $1,493,995.23 = $25,632.27 $25,632.27 / $1,519,627.50 = 1.69% That is a bigger reduction in the value of the contract than the forward market hedge. So if that is Dozier's use of funds, the company would be better off using the forward market. On the other hand, they were borrowing under a credit line at the end of the year at an interest rate of 10.5% (prime + 1%). If they avoid borrowing at least as much as the UK borrowing would provide over the next three months, the company might be better off with the UK loan than it would with the forward rate contract. Here the choice also depends on whether they can actually borrow at a fixed rate of interest for three months and other considerations including accounting issues. or or

We could calculate a breakeven interest ratethe average USD rate that must apply to the dollars received from UK borrowing for Dozier to be indifferent between the two hedging methods. $1,464,701.21 x (1 + i) = $1,501,438.50 (1 + i) = $1,501,438.50/$1,464,701.21 = 1.02508 which is an annual rate of 10.03%. If having cash in the US is worth more than 10%, UK borrowing would be a better hedging method. Shortcut Formulas It's a bit of a pain to do these calculations. Fortunately there is a shortcut. First, for the forward hedge, the following formula can be used: Cost of forward hedge = (Forward Spot) / Spot = (1.4198 1.4370) / 1.4370 = 0.0120 or 1.20 % The negative number shows that it is a "cost". If the result is positive, you are "benefiting" from the hedge relative to the value of the contract at current spot exchange rate. For the money market hedge, the shortcut formula is: Cost of MM hedge = ($ interest rate interest rate) / (1. + interest rate) = (0.02 0.0375) / (1.0375) = 0.0169 or 1.69% If you want to assure yourself that the formulas are correct, set up the calculations we did before algebraically and see how the currency numbers cancel out. The main problem with these formulas is keeping track of which interest rate goes where. There is a handy rule for this. Take the exchange rate quote that you are using, here $/. Think of this in general as X/Y. So, the money market formula is, in general, (X interest rate Y interest rate) / (1. + Y interest rate) or, in shorthand, (X Y) /(1 + Y) So if you were using a yen/dollar quote for the exchange rate, you would have yen rate minus dollar rate divided by one plus dollar rate. Note that none of this really solves Dozier's problem; but there is a theory that in well functioning markets, the results from the two formulas should be equal. In other words, it shouldn't make a difference whether you hedge in the forward market or in the money market. However this theory is based on comparing apples to apples. Here the apples are the financial instruments whose interest rates we are comparing. Our interest rate calculation is based on the cost of a UK bank loan to Dozier compared to rate on a bank CD. The theory works a bit better if you use the Eurodollar rate and the Europound rate in Exhibit 4, but even these are not precisely similar instruments. However, there is another use for the formulas. Banks use them in pricing forward contracts! Suppose that we set the two formulas equal to each other and do some rearrangements using my X/Y approach to stay general and to remind us what we are doing. We can get the following result, solving for the forward rate:

Forward rate = Spot rate x (1 + X interest rate) / (1 + Y interest rate) Remember the rule is X over Y. When the bankers get up in the morning, they turn on their screens, check for spot exchange rates and interest rates, and plug the numbers into the formula. That determines essentially their forward rate quote in a given currency. The time period of the interest rate used determines the time period of the forward rate (e.g. for onemonth forward, use one-month interest rates). So, what does the forward rate tell you? Relative to the spot rate it tells you whether interest rates in one currency are higher or lower than those in the other currency and that's about all. So, the reason that the historical forward rates in the Dozier case are consistently below the spot rates is that interest rates in the US have been consistently below UK rates and the relationship between the relative interest rates have not been changing much either since the forward-spot difference has been fairly stable.