Question

You are a German businessman who is expecting to receive a payment of 4.83 million South African Rand (SAR) nine months from today. The spot exchange rate is 6.11 SAR/€, the expected annual inflation rate in South Africa is 10.5% and in the European Union it is 2.16%.
a) Based on the above, what is your best estimate of the spot exchange rate that will prevail nine months from now?
b) How would you hedge your position if you were to use the money market (Note: describe only)?
c) Suppose that nine months later the spot rate is 6.15 SAR/€ and that the inflation rates forecasts turned out to be accurate. Calculate the real exchange rate and the real % change in the value of the SAR over the past nine months.

Answer 1

a. We will calculate the spot exchange rate by the parity formula.

Future Exchange rate = 6.11 x [(1+0.105)/(1+0.0216)]^(9/12) = 6.48

b. Since I expect to receive 4.83 Million SAR, I would have to sell SAR in the future. Hence, I would go short on SAR/EUR futures so that I am able to receive a fixed amount of EUR in 9 months.

c. The formula for Real Exchange Rate is given as:

RER/Nominal Exchange Rate = Domestic Price/Foreign Price = 1.0216/1.105 = 0.9245

Hence, RER = 0.9245 x 6.15 = 5.686.

% change = (6.15 - 6.11)/6.11 = 0.654%