Zigzag Co operates in a country where the home currency is $. It has recently begun exporting to a European country and expects to receive €500,000 in six months’ time. The company plans to take action to hedge the exchange rate risk arising from its European exports.
Zigzag could put cash on deposit in the European country at an annual interest rate of 3% per year, and borrow at 5% per year. The company could put cash on deposit in its home country at an annual interest rate of 4% per year, and borrow at 6% per year. Inflation in the European country is 3% per year, while inflation in the home country of Zigzag is 4.5% per year.
The following exchange rates are currently available to Zigzag:
Current spot exchange rate: 2.000 euro per $
Six-month forward exchange rate: 1.890 – 1.990 euro = $1
One-year forward exchange rate: 1.883 – 1.981 euro = $1
Zigzag is also considering the use of futures or options contracts but the finance director doesn’t feel that she knows enough about them to make an informed decision.
If Zigzag uses a money market hedge, what values will need to be borrowed and deposited today in setting up the hedge?