1. The hedge funds is a term that many employ to depict any investment fund that uses derivatives strategies to reduce risk on the transaction. Products can vary from funds that support investment decisions on stock picking - mainly of undervalued and distressed stocks. At the other end of the range are funds, which play on macro-economic changes.
Hedging options are:
Forward market hedge
Money market hedge
2. Today In 30 days
Contract to sell pesos forward at Peso 13.1/$ When sales occurs, 7 million Pesos =
7 million / 13.
1 = $534,351.2
3. Today In 30 days
1. Borrow the PV of the Pesos at 15% annually (1.25% monthly) and pay of loan with AR.:
7 million / 1.0125 = 6,913,580.2
2. Convert spot at Peso 13/$, which is $531,813.9
3. Invest money in money market account at 7.5% (annually), which is 0.625% (monthly):
we will have 535,137.7 in 30 days (on dollar market)
Pay of bank-loan at 1.25% (monthly rate).
We are also to consider the cost of capital here.
4. Money market hedge is preferable to forward market hedge because money market hedge gives the investor more control over the situation, thus the risk is further reduced. It has to be noted that if companies could deposit and borrow at bank rates, the money market hedge would equal to forward hedge (IRP). But because borrowing rates are higher in reality, money market hedge is preferable only if the company’s use of the money counterbalances the foreign currency borrowing cost. MM hedge should only be used if the company requires money today.
5. The hedged cost of DKNY’s payable using the option on pesos hedge:
Forward hedge: no risk; money market hedge: outcome depends on investment opportunities. The cost is the difference between the money made out of investing and the money that were paid to the bank for the loan.
6. Cost of the option on pesos equals the cost of the forward market hedge when there is fixed exchange rate. In other words, when we have fixed exchange rate, then there is no volatility and spot = forward.
7. If the 30 day spot rate is expected to be Peso 13.
4/$, the DKNY still had to hedge this payable because if the transaction remains unhedged, the company inquires the risk. The sole aim of hedging is to eliminate or reduce risk. Therefore regardless of the expectations (which are just expectations and they do not provide any solid guarantees), the company is to use the most appropriate hedging option. The factors that influence DKNY decision are the following: how urgent do we need money and what are the costs of the hedging option as well as the cost of capital.
3(a) answer is C
3(b) answer is D
3(c) answer is B.