Question

Chapter 8: Review Problems

Spot Exchange Rate INR/USD	66.77 INR/$
60 Day Forward Exchange Rate INR/USD	63.70 INR/$
Interest Rates on deposits in India	6%/year
Call option exchange rate, 60 days	63.77 INR/$
Cost of options globally	1.25% of contract amount
Spot Exchange Rate USD/GBP	$1.22/£
90 Day Forward Exchange Rate USD/GBP	$1.26/£
Borrowing Rate in US	9%/year
Put option exchange rate, 90 days	$1.15/£

Scenario 2

Tom Brady is purchasing 500 slightly deflated (American) footballs from Sports Direct, a sporting goods store located in the U.K. The total cost of the footballs are £10,000 and the U.K. retailer has agreed to offer 90 days credit terms.

Is the exchange rate provided above shown as a direct or indirect quote in terms of U.S dollars?

Suppose the sporting goods store, Sports Direct, agrees to complete the transaction using Tom Brady’s currency (USD).

What amount would be shown on the invoice if the transaction were completed today?

Show how Sports Direct can use a forward market hedge to manage their transaction exposure. What is the invoiced amount now?

How can Sports Direct use a money market hedge to manage their transaction exposure?

Suppose the spot exchange rate in 90 days ends up being $1.25/£. Show how Sports Direct can use an options market hedge to manage their transaction exposure. Make sure to explain why they would/would not exercise their option.

Answer 1

1. The Quote is a direct quote against the USD in INR and Indirect for quote against GBP.

2.purchase of footballs in UK.

Cost=10000£

Credit term=90 days

Exchange rate provided above is shown as direct quote in terms of U.S. Dollars.

Invoice in terms of US Dollars=10000*1.22=$12200

The “amount due” on the invoice from the manufacturer is $12200.

Forward market hedge to mitigate his transaction exposure:

90 day forward exchange rate 1£=$1.26

90 days spot exchange rate 1£=$1.25

Transaction exposure using forward market=10000*(1.25-1.26)=$(100)

Money market hedge to mitigate his transaction exposure:

Spot rate 1£=$1.22

Need to pay after 90 days=10000*1.22=£12200

A=P(1+i)

i=9% pa=2.25% for 90 days (assumption 360 days)

12200=P(1+0.0225)

On solving, P=11931.5

Money market hedge to mitigate his transaction exposure is 12200-11931.5=$268.5

Options market hedge to mitigate his transaction exposure:

90 day spot rate 1£=1.25$

Call option exchange rate 90 days 1£=1.15$

Hedge=10000*(1.25-1.15)=$1000

Options market hedge to mitigate his transaction exposure is $1000

He would exercise options market hedge to mitigate his transaction exposure as the gain in this is more when compared to forward hedge and money market hedge.