Question

4. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. Air France will be billed €20 million which is payable in one year. The current spot exchange rate is $1.05/€ and the one-year forward rate is $1.10/€. The annual interest rate is 6.0% in the U.S. and 5.0% in France.

Boeing is concerned with the volatile exchange rate between the dollar and the euro and would like to hedge exchange exposure.

(a) It is considering two hedging alternatives: sell the euro proceeds from the sale forward or borrow euros from Credit Lyonnaise against the euro receivable. Which alternative would you recommend? Why?

(b) Other things being equal, at what forward exchange rate would Boeing be indifferent between the two hedging methods?

Answer 1

Answer:

a) a forward hedge is better

b) a forward rate of 1.06 will make both method equal

Explanation:

Solution:  (a)

forward hedge:

20,000,000 x 1.10 = $22,000,000

money market hedge:

PV of Air France payment:

€20,000,000/1.05  = €19,047,619

In dollars at spot rate

€19,047,619 x $1.05/€ = $20,000,000

Then we invest at 6% risk-free:

$20,000,000(1.06) = $21,200,000

(b)

Forward rate:

Spot exchange-rate x US rate/Foreing rate =

1.05 x 1.06 / 1.05 = 1.06