. Money-market Hedge

It turns out that Dozier has also sought suppliers from foreign markets including Canada, and that the US$847,061 materials cost in the bid preparation (see Exhibit 3 in Dozier Part A) is really a translation of Canadian materials cost, CA$1,178,431.26. Dozier used the spot exchange rate on the bid preparation date, December 3, to arrive at the US dollar materials cost. In fact, on January 14 following bid acceptance, Dozier has placed a purchase order with a Canadian supplier as planned, resulting in a Canadian dollar payment due on April 14 in the above amount.

The market rates on January 14 are as follows (based on actual historical rates):

CA$ exchange rate: CA$1.4030/US$

CA$ prime lending rate: 11.00%

CA$ three-month deposit rate: 10.70%

John Gunn of the bank’s International Division suggests that Dozier will be able to borrow in Canadian dollars at 1.00% over the Canadian prime lending rate. Robert Leigh, who is responsible for Dozier’s business with the bank, assures that Dozier can borrow in US dollars at the US prime lending rate flat (see Exhibit 4) given its relationship with the bank. Dozier can make a deposit in either currency at its respective deposit rate; there is no additional spread because a deposit does not concern the depositor’s credit.

a) Construct a money market hedge to fix the amount of US dollars necessary to pay for the Canadian materials cost. Specify the details of the three necessary transactions, i.e., how much of what currency you are borrowing, exchanging, and depositing at what rate. In particular, make sure to choose the correct borrowing and deposit rates.

b) What is the effective forward rate of your money-market hedge? Show at least four digits below the decimal point. Is the Canadian dollar in forward discount or premium in your effective forward contract?

c) In a perfect world in which all parity conditions hold ex post (i.e., without the expectations—see the Big Diamond), was Dozier’s choice to convert the Canadian materials cost by the spot rate as of bid submission conservative, assuming that Canadian interest rates were expected to remain higher than their US counterpart for the relevant future (as they are on January 14—compare the above rates to Exhibit 4)? Support your argument stating which parity condition(s) you are invoking on December 3 and January 14.

Note: It is more conservative to overestimate the cost than underestimate it.

• Attachment 1
• Attachment 2