I am trying to do some self studying and came across this question. I am not sure how I would analyze these hedging strategies to figure out which is better. Could you give me any help on how I could tackle this question?
Company A is in the UK and was commissioned to organize a event in Madrid in 12 months’ time for €450,000. The contract between the two companies stipulated that €100,000 will be paid up front with remaining amount to be paid after the conference. Company A ’s credit line is for €360,000 and the company obtains the following rates:
- Current spot exchange rate = EUR 1.1324 /GBP (1.1324 Euro per British pound)
- Expected spot rate in one year = EUR 1.1812 / GBP (1.1812 Euro per British pound)
- Current one year forward rate = EUR 1.1527 / GBP (1.1527 Euro per British pound)
- One year British pound deposit rate = 0.50%
- One year Euro borrowing rate = 2.30%
Which hedging technique is preferable with regard to this contract: using the forward market or the money market to hedge the foreign exchange risk?