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MC Question 25

ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso interest rates were relatively cheap compared to dollar interest rates. ZPS Co does not have any income in pesos. Economic difficulties have now increased peso interest rates while dollar interest rates have remained relatively stable.

ZPS Co must pay interest on the dates set by the bank. A payment of 5,000,000 pesos is due in six months’ time. The following information is available:

Spot rate12·500–12·582 pesos per $
Six-month forward rate 12·805–12·889 pesos per $
Interest rates which can be used by ZPS Co:
Borrow Deposit
Peso interest rates 10·0% per year7·5% per year
Dollar interest rates 4·5% per year3·5% per year

ZPS Co also trades with companies in Europe which use the Euro as their home currency. In three months’ time ZPS Co will receive €300,000 from a customer.

Which of the following is the correct procedure for hedging this receipt using a money market hedge?

A. Step 1 Borrow an appropriate amount in Euro now
Step 2 Convert the Euro amount into dollars
Step 3 Place the dollars on deposit
Step 4 Use the customer payment to repay the loan
B. Step 1 Borrow an appropriate amount in dollars now
Step 2 Place the dollars on deposit now
Step 3 Convert the dollars into Euro in three months’ time
Step 4 Use the customer payment to repay the loan
C. Step 1 Borrow an appropriate amount in dollars now
Step 2 Convert the dollar amount into Euro
Step 3 Place the Euro on deposit
Step 4 Use the customer payment to repay the loan
D. Step 1 Borrow an appropriate amount in Euro now
Step 2 Place the Euro on deposit now
Step 3 Convert the Euro into dollars in three months’ time
Step 4 Use the customer payment to repay the loan