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Question 1ab
Rose Co expects to receive €750,000 from a credit customer in the European Union in six months’ time. The spot exchange rate is €2·349 per $1 and the six-month forward rate is €2·412 per $1. The following commercial interest rates are available to Rose Co:
| Deposit rate | Borrow rate | |
|---|---|---|
| Euros | 4·0% per year | 8·0% per year |
| Dollars | 2·0% per year | 3·5% per year |
Rose Co does not have any surplus cash to use in hedging the future euro receipt.
Required:
(a) Evaluate whether a money market hedge or a forward market hedge would be preferred on financial grounds by Rose Co. (5 marks)
(b) Briefly explain the nature of a forward rate agreement and discuss how a company can use a forward rate agreement to manage interest rate risk. (5 marks)