Long-Term Hedging
Response to the following problem:
Rebel Co. (a U.S. firm) has a contract with the government of Spain and will receive payments of 10,000 euros in exchange for consulting services at the end of each of the next 10 years. The annualized interest rate in the United States is 6 percent regardless of the term to maturity. The annualized interest rate for the euro is 6 percent regardless of the term to maturity. Assume that you expect that the interest rates for the U.S. dollar and for the euro will be the same at any future time, regardless of the term to maturity. Assume that interest rate parity exists. Rebel considers two alternative strategies:
Strategy 1 It can use forward hedging 1 year in advance of the receivables, so that at the end of each year, it creates a new 1-year forward hedge for the receivables.
Strategy 2 It can establish a hedge today for all future receivables (a 1-year forward hedge for receivables in 1 year, a 2-year forward hedge for receivables in 2 years, and so on).'
a. Assume that the euro depreciates consistently over the next 10 years. Will Strategy 1 result in higher, lower, or the same cash flows for Rebel Co. as Strategy 2?
b. Assume that the euro appreciates consistently over the next 10 years. Will Strategy 1 result in higher, lower, or the same cash flows for Rebel Co. as strategy 2?