PQR Associates will owe EUR 100000 in one year It is concern

PQR Associates will owe EUR 100,000 in one year. It is concerned about appreciation of the EUR and is considering possible hedging techniques. The following market and exchange conditions apply: One Year Forward Rate EUR Interest Rate US Interest Rate USD 1.20 5% 8% Call Option Exercise Price Call Option Premium Today’s Spot Rate USD 1.20 USD .03 USD 1.18 PQR has forecasted exchange rates and has developed the following probability distribution for the expected 1 year exchange rate: 1 Year Exchange Rate USD 1.16 USD 1.22 USD 1.24 Probability 20% 70% 10%

If PQR hedges with a Forward Hedge, what is the cost of their payables in 1 year?

Solution

In forward rate hedge, an exchange rate is fixed in advance, and the currencies are exchanges at the same rate in the future date

One year Forward rate is 1 Euro = 1.20 USD

Euro required = 100,000

Hence, cost of payables in forward rate hedge = 100000*1.2 = USD 120,000