Application Comparing Hedging Alternatives When There Are Transaction Costs 
Possible Outcomes of Money Market Hedge as of December 31
Application Comparing Hedging Alternatives When There Are Transaction Costs
PespsiCo would like to hedge its C$40 million payable to Alcan, a Canadian aluminum producer, which is due in 90 days. Suppose it faces the following exchange and interest rates:
Spot rate:
$0.9422-31/C$
Forward rate (90 days):
$0.9440-61/C$
Canadian dollar 90-day interest rate (annualized):
4.71%—4.64%
U.S. dollar 90-day interest rate (annualized):
5.50%-5.35%
Which hedging alternative would you recommend? Note that the first interest rate is the borrowing rate and the second one is the lending rate.
Solution. The hedged cost of the payable using the forward market is U.S. $37,844,000 (0.9461 × 40,000,000), remembermg that PepsiCo must buy forward Canadian dollars at the ask rate. Alternatively, PepsiCo could use a money market hedge. This hedge would entail the following steps:
1. Borrow U.S. dollars at 5.50% annualized for 90 days (the borrowing rate). The actual interest rate for 90 days will be 1.375% (5.50% X 90/360).
2. Convert the U.S. dollars into Canadian dollars at $0.9431 (the ask rate).
3. Invest the Canadian dollars for 90 days at 4.64% annualized for 90 days (the lending rate) and use the loan proceeds to pay Alcan. The actual interest rate for 90 days will be 1.16% (4.64% X 90/360).
Since PepsiCo needs C$40 million in 90 days and will earn interest equal to 1.16%, it must invest the present value of this sum or C$39,541,321 (40,000,000/1.0116). This sum is equivalent to U.S.$37,291,420 converted at the spot ask rate (39,541,321 × 0.9431). At a 90-day borrowing rate of 1.375%, PepsiCo must pay back principal plus interest in 90 days of U.S.$37,804,177 (37,291,420 × 1.01375). Thus, the hedged cost of the payable using the money market hedge is $37,804,177.
Comparing the two hedged costs, we see that by using the money market hedge instead of the forward market hedge, PepsiCo will save $39,823 (37,844,000 − 37,804,177). Other things being equal, therefore, this is the recommended hedge for PepsiCo.