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dozier hedging

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Dozier Hedging Alternatives Forward Market Hedge: Dozier would purchase U.S. dollars under a forward contract. The contract would obligate Dozier to pay £1,057,500 in exchange for £1,057,500 x 1.4198 $/£ = $1,501,438.50 assuming the transaction was at the quoted 3-month forward rate in Exhibit 4. Relative to the value of the contract at the current exchange rate, £1,057,500 x 1.4370 $/£ = $1,519,627.50 Dozier would accepting a reduction in the revenue from the contract of $1,519,627.50 - $1,501,438.50 = $18,198.00 or $18,198 / $1,519,627.50 = 1.20% Money Market Hedge: In this case, Dozier would borrow an amount of British pounds that would obligate Dozier to a principal and interest payment in three months that …show more content…

Think of this in general as X/Y. So, the money market formula is, in general, (X interest rate – Y interest rate) / (1. + Y interest rate) or, in shorthand, (X – Y) /(1 + Y) So if you were using a yen/dollar quote for the exchange rate, you would have yen rate minus dollar rate divided by one plus dollar rate. Note that none of this really solves Dozier 's problem; but there is a theory that in well functioning markets, the results from the two formulas should be equal. In other words, it shouldn 't make a difference whether you hedge in the forward market or in the money market. However this theory is based on comparing apples to apples. Here the apples are the financial instruments whose interest rates we are comparing. Our interest rate calculation is based on the cost of a UK bank loan to Dozier compared to rate on a bank CD. The theory works a bit better if you use the Eurodollar rate and the Europound rate in Exhibit 4, but even these are not precisely similar instruments. However, there is another use for the formulas. Banks use them in pricing forward contracts! Suppose that we set the two formulas equal to each other and do some rearrangements using my X/Y approach to stay general and to remind us what we are doing. We can get the following result, solving for the forward rate: Forward rate = Spot rate x (1 + X interest rate) / (1 + Y interest rate) Remember the rule is X over Y. When

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