Question

The recent market data on the U.S. and UK are shown as:

the spot rate of the UK pound $1.27/£

the 90-day forward rate $1.29/£

the 180-day forward rate $1.30£

interest rate (TB) in the U.S.: 3% (per year)

interest rate (TB) in the UK.: 1% (per year)

If you have $1 million available for 6 months, where do you want to invest (assume no transaction costs)? Explain why. Please apply all three decision-making rules, as discussed in class, and show that your answers are consistent.

Answer 1

a. $1 million must be invested which has a higher exchange rate. Let us calculate 90-day forward rate and 180-day forward rate using IRP formula,

F = (Spot price) * ((1+foreign interest rate)/1+base interest rate))^n

F is the forward exchange rate

Spot price is $1.27

Foreign interest rate is 1% or 0.01

Base interest rate is 3% or 0.03

n is the number of time periods

Forward rate for 90-day would be $1.27 * (1.01/1.03)^(90/360) = $1.263(Rounded off to 3 decimals)

Forward rate for 180-day would be $1.27* (1.01/1.03)^(180/360) = $1.265(Rounded off to 3 decimals)

Forward rate given for 90-day contract is $1.29. So the premium is 1.29 - $1.263 = $0.027

Forward rate given for 180-day contract is $1.30. So the premium is 1.30 - $1.265 = $0.035

premium is more for 180-day contract as the funds are available for only 6 months, it is good to invest $1million in 180-day forward contract.