Question

3. Trading in foreign exchange

What are spot rates and forward rates?

Suppose you open the newspaper today and observe the following indirect exchange rate quotations for the British pound:

	Spot Exchange Rates	Forward Exchange Rates
		30 Days	60 Days	90 Days
British pound (pound / dollar)	0.5415	0.5433	0.5445	0.5467

The British pound is selling at a   in the forward market.

Suppose you make a £ 600,000 sale to a British customer who has 60 days to pay you in cash. The customer will pay you in British pounds, but your company is based in the United States, so you are most concerned with the dollar value of the payment. If the customer pays you £ 600,000 today, how much is that worth in dollars?

$1,108,033

$831,025

$775,623

$1,163,435

Assume that the forward market is correct and the 60-day forward exchange rate quoted in the newspaper today (above) is the spot exchange rate 60 days from now. If the customer waits the full 60 days and pays you £600,000, how much have you lost (in dollar terms) due to exchange rate fluctuations?

$4,884

$6,716

$6,105

$4,579

Answer 1

Spot Rate is the exchange rate prevailing today i.e. the rates applicable if you exchange currency today.

Forward rate is the rate quoted for future i.e. the rate which you can book today to exchange currency in future.

The British pound is selling at a DISCOUNT in the forward market (since more pounds per dollar)

If received today = 600,000/0.5415

= $1,108,033

If received after 60 days = 600,000/0.5445

= $1,101,928

Value Lost = $1,108,033 – 1,101,928

= $6,105