Question

Consider a U.S.-based company that exports goods to England. The U.S. Company expects to receive payment on a shipment of goods in three months. Because the payment will be in British pound, the U.S. Company wants to hedge against a decline in the value of the British pound over the next three months. The U.S. risk-free rate is 2.32 percent, and the British risk-free rate is 0.72 percent. Assume that interest rates are expected to remain fixed over the next six months. The current spot rate is £0.71/$.

(a) Indicate whether the U.S. Company should use a long or short forward contract to hedge currency risk.

(b) Calculate the no-arbitrage price at which the U.S. Company could enter into a forward contract that expires in three months.

Answer 1