Question

You believe the Swiss franc will appreciate versus the U.S. dollar in the coming three-month period and have $100,000 to invest. The current spot rate is $0.5640/CHF, the three-month forward rate is $0.5820/CHF, but you expect spot rates to reach $0.6250/CHF in three months.

a. Calculate the expected profit from a pure spot market speculation strategy.

b. Calculate the expected profit assuming that you buy or sell the SF three months forward (whichever is appropriate).

c. Why might you prefer the forward contract to the spot market strategy?

Answer 1

a.expected profit from a pure spot market speculation strategy:

Buy CHF today at spot rate and sell at spot rate after 3 months

CHF bought = 100,000/0.5640 = CHF 177,304.96

Sell and get 177,304.96*0.6250 = $110,815.6

Expected profit = $110,815.6-$100,000 = $10,815.6

B.buy today and sell 3 months forward

Proceeds from sale = 177,304.96*0.5820 = $103,191.49

Expected profit =$3,191.49

C.forward contract will be preferred because it will lead to certainty of profits, since forward contract bought today will be executed at the fixed rate in future. On the other hand, spot market price might not turn out as per expectations, which might lead to lesser profits and even loss