Question

III. Forward contracts

The following quotes for the British pounds, on March 22, 2018, are taken from the Wall Street Journal’s Exchange Rates table:

Spot rate:                           $1.4161/£

1-month forward rate:       $1.4158/£

6-month forward rate:       $1.4135/£

Please answer the following questions based on the quotes:

1.Is the pound sterling at a forward premium or discount against the dollar? Please explain.

2.On March 22, 2018, General Motors (GM) expects to receive £10 million in six months from an international trade deal. The company worries about a potential decline in the value of the foreign currency. The spot and forward rates are given above. Please answer the following questions:

a.If GM does nothing today, what is the risk facing GM? Please elaborate.

b.If GM uses a six-month forward contract to cover the risk, how much will the firm receive (in dollars) six months from today?

please give step by step solution

Answer 1

1) The pound sterling is trading at forward discount as the forward quotes have less dollar per value of pound for 1 month as well as 6 month forward rate. It means dollar is strrenghening against pound.

2) As per forward rates, if they materialize, the pound in future will be worth less and there would be less dollars for each pound. Hence the risk for GM is that dollar will strenghen and it will receive less dollar for each pound. Hnece this is the risk for not hedging. Even after hedging we see that the quotes are at discount, so there shall be a loss as compared to spot rates. However hedging shall reduce the risk of further decline in pounds value.

b) If GM used 6 month contract, it shall receive = 10,000,000*1.4315=USD 14,315,000