Question

5. The current spot exchange rate is £0.95/$ and the three-month forward rate is £0.91/$. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be £0.93/$ in three months. Assume that you would like to buy or sell £2,000,000. a. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation? b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be £0.88/$.

Answer 1

Option 1:

Forward cover to BUY £2,000,000 @ rate of £0.91/$ with CALL/PUT option and

1. CALL the option and SELL spot after 3 months @ £0.93/$, if the spot exchange rate is going to be £0.93/$ in three months,
2. PUT the option, if the spot exchange rate turn out to be £0.88/$ in three months

• Expected profit of £ 40,000 @ 0.02/$ [i.e (£0.93/$ - £0.91/$) * £2,000,000]
• In terms of $ is 40000/0.93 = $ 43,010.75

Option 2:

Forward cover to SELL £2,000,000 @ rate of £0.91/$ with CALL/PUT option and

1. PUT the option, if the spot exchange rate is going to be £0.93/$ in three months,
2. CALL the option, if the spot exchange rate turn out to be £0.88/$ in three months

• Expected profit of £ 60,000 @ 0.03/$ [i.e (£0.91/$ - £0.88/$) * £2,000,000]
• In terms of $ is 60000/0.88 = $ 68181.82

Conclusion:

As the option 2 results in higher expected speculative profit, We shall take forward cover to SELL £2,000,000 @ rate of £0.91/$ with CALL/PUT option, which yields Expected profit of $ 68181.82