The Jennette Corporation, a firm based in Mt. Pleasant, South Carolina, has an account payable with a British firm coming due in 180 days. The payable requires Jennette to pay £200,000. Winthrop Jennette, the firm's founder and CEO, is an astute manager. He has asked his CFO, Artis Montgomery, to advise him on the various options for dealing with the exchange risk inherent in this payable. He wishes to know the expected dollar cost of (1) a forward hedge, (2) a money market hedge, and (3) remaining unhedged.
The following information is available to Artis. The spot rate of the pound today is $1.50. The current 180-day forward rate of the pound is $1.47. Interest rates are as follows:
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United Kingdom
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United States
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180-day deposit rate
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4.5%
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4.5%
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180-day borrowing rate
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5.0%
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5.0%
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a. What is the expected dollar cost of the forward hedge?
b. What is the expected dollar cost of the money market hedge?
c. What is the expected dollar cost of remaining unhedged?
d. Which alternative do you recommend? What are the risks associated with this recommendation?