– A company could accomplish the same expectation as hedging through borrowing funds in the required currency at an existing interest rate, and exchange those funds for the local currency at the existing exchange rate.
– If carefully calculated, the exact amount of dollars required so as to pay off the loan with the cash expected from collecting receivables at a future time point;
Amount borrowed = $ receivable / (1 + existing interest rate).
– This loan amount is then switched to local currency at the spot rate. The local currency is then invested for the duration of the loan at the local interest rate.
– The receivables, when received, are then used to pay off the original loan.
– The cash proceeds to the company would be exactly the same as if the company had purchased the foreign funds in the forward exchange market.
– This is a necessity of foreign exchange and interest rate markets, due to interest rate parity.
– Interest rate parity ensures that borrowing or lending in one currency at the interest rate applying will produce the same final wealth as borrowing or lending in any other currency at its interest rate.
– Interest rates must therefore adjust to ensure such parity or there will be arbitrage opportunities. The following relationship must hold;
Relative interest rate = Relative forward exchange discount / premium.
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