Case study $3$

On $25$th January $2021$ Pinaple, a Brazilian importer was sent an invoice for USD $10,500,000$ from a US company, payable on $25$th February.

The spot exchange rates for the two currencies and one$-$month interest rate spreads are:

USD per $1$ Brazilian BRL $0\mathrm{.}2723$

Brazilian one$-$month interest rate: $6\mathrm{.}45\%-6\mathrm{.}55\%$

USA one$-$month interest rate spread: $2\mathrm{.}25\%2\mathrm{.}28\%$

The table below provides details of Brazilian BRL$/$US dollar currency futures on $25$th January $2021.$

BRL$/$USD Futures: Contract Size BRL$100,000$

Contract Settlement Date Futures Price

$3$rd March $2021$ $$0\mathrm{.}2713$

$2$nd June $2021$ $$0\mathrm{.}2703$

Required

a$)$Critically explain the currency risk that the Brazilian importing company faces in connection with the US dollar payment.

$(2$ Marks$)$

b$)$ Compute the one$-$month forward rate of exchange that the Brazilian importing company can fix using a money market hedge.

$(5$ marks$)$

c$)$Construct a hedge against exchange rate risk for the Brazilian importing company using futures contracts.

$(3$ Marks$)$

d$)$ Assume that on $25$th February $2021$ the Brazilian BRL$/$ US Dollar spot exchange rate is USD$0\mathrm{.}2500$ and the price of the futures contract

you chose for the hedge in part c$)$ is USD$0\mathrm{.}2498.$ Show how effectively the hedge works to protect the Brazilian company from exchange rate risk.

$(15$ marks$)$