Question

The current spot exchange rate is $1.70/£ and the three-month forward rate is $1.71/£. You believe that the spot exchange rate will be $1.69/£ in three months.

(1) What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation? Assume that you would like to buy or sell £1,000,000 forward.

(2) What is your dollar profit if the spot exchange rate turns out to be $1.79/£ in three months?

(3) Diagram the dollar profit schedule (for the position you take) against the future spot rate expressed in American terms.

Answer 1

Solution:

(1)

Current three month forward rate = $1.71/£.
Expected spot rate after three months = $1.69/£.

So, we should sell £1,000,000 forward as we will be able to buy at the expected spot rate of $1.69/£ and sell at the higher forward rate of $1.71/£.

Expected dollar profit = Sell amount x [Forward rate - Spot exchange rate]
= £1,000,000 x [$1.71 - $1.69]
= 1,000,000 x $0.02
= $20,000

Therefore, the expected dollar profit from the speculation is $20,000.

(2)

Spot exchange rate turns out to be $1.79/£
Forward rate = $1.71/£.

We are selling £1,000,000 forward.

Expected dollar profit = Sell amount x [Forward rate - Spot exchange rate]
= £1,000,000 x [$1.71 - $1.79]
= 1,000,000 x -$0.08
= -$80,000

Therefore, the expected dollar profit/loss from the speculation is -$80,000.

(3)