Question

3. You are concerned about your transaction exposure on a recent purchase from an exporter in Great Britain. The invoice, just received, is for 275,000 pounds sterling payable in 90 days, which will be about mid-June. The current exchange rate is $1.35 per pound sterling, and you fear that the dollar will depreciate against the pound due to the relatively low interest rates currently prevailing in the United States. The following forward rate is $1.38.

a.  What is the cost of the invoice in dollars at the current spot rate?

b.  If a forward contract is purchased, what will be the cost of the invoice in dollars at the forward rate?

c.  Describe the advantages and disadvantages of hedging the transaction with a forward contract.

Answer 1

The solutions are as follows:

a) The cost of the invoice in dollars at current spot rate is = 275000*1.35 = $371250

b) The cost of the invoice in dollars at forward rate is = 275000*1.38 = $379500

c) The advantages of a forward contract are

1) They can be matched against the time period of exposure as well as for the cash size of the exposure.

2) Forwards are tailor made and can be written for any amount and term.

3) It offers a complete hedge.

4) Forwards are over-the-counter products.

5) The use of forwards provide price protection.

6) They are easy to understand.

The disadvantages of forward contracts are:

1) It requires tying up capital. There are no intermediate cash flows before settlement.

2) It is subject to default risk.

3) Contracts may be difficult to cancel.

4) There may be difficult to find a counter-party.