Question

Scenario: Jim Logan, the owner of an American based small business, Sports Exports, Inc., specializes in exporting footballs to Great Britain. In return, he receives payments in British pounds every month which need to be converted into dollars. He has noticed that the exchange rate between the dollar and the pound at the time of exchange every month is significantly affecting his profits. Since he is a small business owner and not a foreign currency expert, he has hired your consulting firm to advise him with respect to the following matters below. A) Jim Logan recently heard on CNBC that inflation is expected to rise substantially in the United Kingdom, while inflation in the United States will remain low. They also expect that the interest rates in both countries will rise by about the same amount. He asks you to answer the following questions so that he may take the appropriate measures if CNBC is correct in their projections.

1. From an economic perspective, will the pound appreciate or depreciate against the dollar and explain why?

2. Will Sports Exports, Inc. be favorably or unfavorably affected by the future changes and explain why?

3. How can Sports Exports, Inc. use currency futures contracts to hedge against exchange rate risk? Are there any limitations of using currency futures contracts that would prevent Sports Exports, Inc. from locking in a specific exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months?

4. How can Sports Exports, Inc. use currency options contracts to hedge against exchange rate risk? Are there any limitations of using currency futures contracts that would prevent Sports Exports, Inc. from locking in a specific exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months?

5. While Mr. Logan believes the CNBC report, he would also like to know what to do if CBNC is incorrect specifically with respect to using futures or options to hedge the exchange rate risk in this opposing scenario? Are there any disadvantages in this scenario?

Answer 1