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Risk ManagementSection BRisk ManagementForeign Exchange RiskMoney Market Hedge

ACCA · Question 27 · Risk Management

Section B - Case 3: LithiumX

Scenario: LithiumX is a cross-border mining company based in the US. It expects to receive €2,000,000 in exactly 3 months from a European client.
Spot exchange rate: €1.1500 - €1.1550 / $1
3-month forward rate: €1.1600 - €1.1640 / $1
US interest rates: 4% borrow, 2% deposit (annual)
Euro interest rates: 5% borrow, 3% deposit (annual)

Question: What is the first step LithiumX must take to set up a money market hedge for this €2,000,000 receipt?

Answer options:

A.

Deposit US Dollars now at the US deposit rate.

B.

Borrow Euros now at the Euro borrowing rate.

C.

Borrow US Dollars now at the US borrowing rate.

D.

Deposit Euros now at the Euro deposit rate.

How to approach this question

A money market hedge for a receipt involves creating a liability in the foreign currency to offset the future asset. Therefore, you borrow the foreign currency today.

Full Answer

B.Borrow Euros now at the Euro borrowing rate.✓ Correct
To hedge a future foreign currency receipt using the money markets, the company must: 1. Borrow the foreign currency (Euros) today. The amount borrowed plus interest will exactly equal the €2m receipt in 3 months. 2. Convert the borrowed Euros into domestic currency (US Dollars) immediately at the current spot rate. 3. Deposit the US Dollars in a US bank account to earn interest for 3 months. When the €2m is received from the client, it is used to immediately pay off the Euro loan.

Common mistakes

Confusing the steps for hedging a receipt (Borrow foreign, convert, deposit domestic) with hedging a payment (Borrow domestic, convert, deposit foreign).
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