ABC Co just sold a ship to Ship France, Inc

Given that ABC Co will be receiving Euro 20,14 million in 1 year

a)

Heding using forward contract

Given that the forward rate is $1.12/€

Hence Dollar receivable in 1 year will be 20.14 * 1.12 = 22.5568 Million Dollars

Hedging using money market hedge

We will be receiving Euro in 1 year

So we will borrow that amount in Euro and invest in dollar so that we can eliminate the transaction exposure

Accordingly, Amount of Euro to be borrowed is 20.14/1.07 = 18.822429 Million Euro

Now we will invest this in dollars

Amount of dollars = (20.14/1.07)*1.09 = 20.51644 Dollars

Dollars recievable after 1 year will be 20.51644 + 20.51644 * 0.08 = 22.15776

hence we can see that the forward contract is yielding higher than the money market hedge so it is preferred to have the forward cover only

b) Since interest rates in US and France are different we have to have a theoretical forward rate as per the covered interest rate arbitrage theory(CIA)

According to CIA

F = S * (1+ia)/(1+ib)

Where F is the forward rate

ia is the interest rate in domestic country

ib is the interest rate in foreign country

Hence the required exchange rate to be indifferent between two alternatives is

F = 1.09 * (1.08)/(1.07)

F = 1.1

Hence the required forward rate is $1.1/Euro