Question

The current spot exchange rate is $1.45/€ and the three-month forward rate is $1.55/€. Based on your economic forecast, you are pretty confident that the spot exchange rate will be $1.50/€ in three months. Assume that you would like to buy or sell €100,000.

a) List and discuss what actions would you take to speculate in the forward market (take a short or long position and why)

b) Critically discuss what is the expected dollar profit from speculation

c) If current spot exchange rate is $1.45/€ and the three-month forward rate is $1.55/€, assess and evaluate what is the forward premium (discount). Is it expected that dollar will appreciate or depreciate?

Answer 1

Answer:

(a)

We can enter in a three-month forward contract to sell or short pound at $1.55 per pound. As per our economic forecast and analysis, the three-month spot exchange is $1.50 per pound, therefore we must buy or long pound at $1.50 per pound. Further, in speculative market, the buy is set off against the sell or vice versa without any actual delivery. The forward rate quoted is higher than the expected three-month spot rate, therefore we must take short or sell the the three-month forward contract.

Take a short position in forward market on euro to make profit of $5,000.

(b)

Expected dollar profit from speculation = 100,000 x (1.55 - 1.50)

= $5,000

(c)

spot rate = $1.45 per pound ; 3 month forward rate = $1.55 per pound. Therefore, it is evident that dollar is depreciating against pound. Hence, it is expected that dollar will depreciate against pound at 3-month's spot rate.

Now, Premium or discount = [(Forward rate - Spot rate) / Spot rate] x 12/3months x 100

= [(1.55 - 1.45) / 1.45] x 12/3 x 100

= 27.59%

Pound is at 27.59% premium.

Now, Dollar is at discount, let us calculate the %,

= (1/1.55 - 1/1.45) / 1/1.45 x 12/3 x 100

= (0.65 - 0.69) / 0.69 x 12/3 x 100

= - 23.19%

Good Luck!