the italian airline alitalia will pay $10 million to United Airlines one year from today. The spot rate is $1.35/E, while the 1-year forward rate is $1.40/E. The 1-year interest rate in the US is 5%, and the 1-year interest rate in the Euro Zone is 3%. What should alitalia do to hedge its transaction exposure

alitalia should do the forward hedge to hedge its transaction exposure

Explanation:

Alitalia can construct the money market hedge as follows

1. borrow Euro whose present value is equal to the amount to be paid.

2. convert it to foreign currency at the current spot rate.

3. place it in a deposit

4. make the payment when the deposit reaches maturity

PV of payment = 10000000/1.05

= 9523809.525

converting in to Euro at the spot rate we get 6802721.09 Euros

so Alitalia has to borrow the above amount and convert it and invest it at 5%.

now the payable amount from the loan is 6802721.09 (1+0.03) = 7006802.72 Euros

Hence Alitalia has effective managed to locl in a forward rate of 1.427$/euros (10000000/7006802.72) $/euros

Therefore, alitalia should do the forward hedge to hedge its transaction exposure