money market hedging forward hedging exchange rates

HB Corp., a UK company, has subsidiaries in the U.S., Germany, Singapore and Australia. It regularly sells goods denominated in U.S. dollars. The company will have two transactions in the near future:

Three months (90 days): Paying 400,000 Euros for imported goods

Six months (180 days): Receiving 600,000 USDs for exports

The following exchange rates and interest rates are available for the company:

Bid Quote Ask Quote

(bank buys) (bank sells)

Spot exchange rate (Euro per £1): 1.17 1.13

Three-month forward rate (Euro per £1): 1.10 1.05

Spot exchange rate (USD per £1): 1.217 1.188

Six-month forward rate (USD per £1): 1.202 1.178

Spot exchange rate (AUD per £1): 1.762 1.735

1-year forward rate (AUD per £1): 1.765 1.738

1 year (360 days) interest rates:
Borrow Deposit

USD 7.8% 4.0%

Pound 6.7% 2.4%

Euro 6.2% 3.2%

AUD 7.8% 5.2%

a) Suggest how HB Corp. could implement a money market hedge for payables, support your answer with detailed calculations. Would HB Corp. be better off using forward hedge or money market hedge? Substantiate your answer with estimated cost each type of hedge. (10 marks)

b) The company has recently received £800,000 and is considering invest in Australia to exploit the higher interest rate. What is the yield to the company if it conducts a covered interest arbitrage? Would covered interest arbitrage work for the company in this case? (Ignore transaction fees and tax effects.) (10 marks)

c) Based on the question above, discuss how the Australian dollar’s spot and forward rates will adjust until covered interest arbitrage is no longer feasible. Why are arbitrage opportunities diminishing quickly after they have been discovered? To illustrate your answer, assume that the immediate purchase and forward sale of Australian dollar is allowed. What is the resulting equilibrium state referred to? (8 marks)

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