FREE online courses on Investment Decisions in Exchange Rates - Hedging an Account Payable

 

Similarly, can hedge an account payable by entering into a forward contract to buy the foreign currency at a price of F$/F per unit of foreign currency.  The present value of this strategy is

 

                   F$/F  .

 

Alternatively, since the present value (discounted at the foreign interest rate) of a liability of one unit of foreign currency is 1/(1+RF) , we can eliminate any exchange rate risk associated with the future liability by immediately converting

 

                   S$/F

 

dollars to units of foreign currency and investing at the foreign interest rate of RF .  When the liability comes due, this number of present dollars is guaranteed to be equal to 1 unit of foreign currency, which can then be used to pay the foreign currency denominated payable.

 

Example: (Hedging an Account Receivable)

 

Assume that your firm has an account receivable of one million Swiss francs that is due to be received in 180 days.  The spot exchange rate (S$/F ) is $0.8800/SF1 , while the forward exchange rate ( F$/F ) for delivery in 180 days is $0.8950/SF1.  The interest rate in the U.S. for a 180 day period (RUS ) is 2.6 percent while the Swiss rate of interest (RF ) for 180 days is 1 percent.

 

The present value of selling the francs in the forward market is

 

                   F$/F  SF1,000,000         =      $0.8950/SF1  SF1,000,000 ,

 

                             =      $872,319.69  .

 

The present value from borrowing the present value of the receivable (denominated in units of foreign currency) and converting to dollars is

 

                   S$/F SF1,000,000  =     $0.8800  SF1,000,000  .

 

                             =     $871,287.13   .

 

Since the present value of selling the currency in the forward market is $872,319.69 while the present value of the money market hedge is $871,287.13, it would be better to hedge by selling the currency forward.

 

If we needed to hedge an account payable of SF1,000,000 due in 180 days, the amounts above would represent the present value of the cost of hedging.  In this case, we would go with a money-market hedge, since the present value of the money-market hedge ($871,287.13) is less than the cost of hedging in the forward market.