Question

) You recently attended a one day seminar titled "How to make money on foreign currency exchange rates". You are eager to try out the new things you learned. You go the Wall Street Journal and find that the 6 month forward for the Euro is $1.2527. You have $10,000 to invest.

Answer the following:

a.) If you predict the future spot rate will be $1.30 what position should you take? If correct, what is your profit?

b.) If you predict the future spot rate will $1.20 what position should you take? If correct, what is your profit?

Answer 1

If future spot rate = $1.30, it means forward market is undervalued hence it is better to take long position ( agree to buy in forward market). After six months, we shall have 10000/1.2527 euro, which can be sold for $ 1.30 at that time. Thus value of investment after six months = 10000/1.2527 Euro * $ 1.30 = $ 10378

Thus the profit = 10378 - 10000 = $ 378

question - b

In this case, we see forward market is overpriced compared to our own expectation. Here also we can take it to our advantage by taking short position in forwards ( agree to sell). After six months we can buy 10000/1.20 Euro in the then spot market and sell at $ 1.2527 per Euro in forward market.

Thus we get 10000/1.20 Euro * $ 1.2527 = $ 10439

Profit = 10439 - 10000 = $ 439