Question

On May 6, 2013, the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.5532

This obligates the corporation to pay $1,553,200 for £1 million on November 6, 2013

What are the possible outcomes?

Answer 1

Forward contract exchange rate is given as £:$ = 1.5532. Here pound is quoted in terms of dollars which means £1 = $1.5532. This is a direct quote from American point of view.

There are 3 possible outcomes.

A) Exchange rate on Nov 6, 2013 is 1.5532

=> The company will pay $1,553,200 as per the contract. It will result in no gain/loss as current exchange rate is also same.

B) Exchange rate on Nov 6, 2013 is more than 1.5532 (Suppose:1.5732)

=> Here, dollar depreciated.The company will pay $1,553,200 as per the contract instead of $1,573,200 if it had not made the contract. This will result in profit of $20,000 ($1,573,200 - $1, 553,200)

C) Exchange rate on Nov 6, 2013 is less than 1.5532 (Suppose: 1.5432)

=> Here, the dollar appreciated. The company will pay $1,553,200 as per the contract instead of $1,543,200 if it had not made the contract. This will result in loss of $10,000 ($1,553,200 - $1,543,200) because company already made a forward contract at exchange rate of 1.5532