1. (This problem is worth 4 of the 10 points in this assignment). Assume that a U.S. firm has ordered a major piece of machinery from a Japanese firm for ¥3 million, and that the current exchange rate is 106 ¥/$ (i.e., the current cost of the machinery in dollars is $28,302).  The payment for the machinery, to be made in Yen, is due in 6 months and the firm will borrow at its bank at a 6% p.a. rate[1]. The U.S. firm is concerned about appreciation of the Yen, which would lead to a greater cost than planned.  Therefore, the firm is considering two possible transactional hedges: (1) entering into a forward contract, or (2) creating a money market hedge.

REQUIRED:

  1. Explain what exact steps the firm should take in each of the possible hedges (i.e., what positions). Assume that 6-month forward contracts are currently available at an exchange rate of 103.5¥/$; the relevant interest rate in Japan is 3% p.a. (1/2 point)
  2. You learned from week 6 that both the money market hedge and the forward hedge lock in the cost of the machinery. What is that cost to the U.S. firm (in dollars) in 6 months?  Show your work. (2 points)
  3. Which hedge would be the best choice? Hint: There is less than $300 difference between the two choices. (1/2 point)
  4. By what amount would the firm be better or worse off if it simply paid for it today? To be consistent you need to consider the time value of money and we will assume the 6% rate as the opportunity cost of paying today rather than in 6 months. (1 point)

[1] p.a. is notation for per annum; in other words, this rate is the interest rate for 1 year.

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