Question

Short-Run Exchange Rate Risk

Assume you have a trade receivable denominated in a foreign currency of your choice that is payable to you by your customer in 6 months. At the current spot rate the trade receivable is worth the equivalent of US$5,000,000. To find the current spot rate for the chosen currency pair go to http://www.hsbcnet.com/gbm/fxcalc-disp.[1] Enter 5,000,000 in the “Convert” box, United States dollar in the “From:” box, and your chosen currency in the “To:” box. Click on “Go” for the spot rate, which will be expressed in European terms, that is, units of foreign currency per one US dollar. Enter the name of the chosen currency, the date the site is accessed, and the spot rate in European terms in the table below.

To find a 180 day forward rate for the currency pair, go to http://www.hsbcnet.com/gbm/fwcalc-disp#. For “Amount” you can just enter 1 and enter US dollars in the “Buy” box and the foreign currency in the “Sell” box. For “Value Date” enter “6 Months” and click “Go” for the forward rate. (Clicking on the Inverse box will switch the rate from European to American terms.) Enter the one-year forward rate in the table below. Make sure the forward rate is expressed in the same way as the forward rate, that is, in European terms.

Foreign Currency	Date	Current Spot Rate in European terms: FX per   1 US dollar	Six -Month Forward Rate in European terms: FX per 1 US dollar
Australia AUD Australian dollar	9/19/18	Spot Price(USD): 0.7267 Spot Price (AUD): 0.7285	AUD Sell Amount: 1.37 Forward Rate: 1.3744

Based on the data above, answer the following questions:

At the current spot rate how much in the foreign currency are you owed in 6 months? Assuming you fully hedge your FX exposure in the forward market, how many US dollars will you receive in 6 months? Is the foreign currency selling in the forward market at a premium, i.e. it appreciates relative to the spot rate, or a discount, i.e., it depreciates relative to the spot rate? Provide numbers to support your answer.

Long-Run Exchange Rate Risk

Assume you have undertaken a 3-year investment abroad with expected cash flows denominated in your chosen currency. At the current spot rate those cash flows are expected to provide a positive net present value (NPV) in US dollar terms. Based on relative purchasing power parity you are asked to estimate future spot rates over the next three years based on comparative inflation data.[2] With that data complete the table below.

S0 = Current Spot Rate in European Terms (Foreign currency per US dollar)	E(St) = Expected Exchange Rate Spot Rate in t Years in European Terms (Foreign currency per US dollar)	hUS= Annual Inflation Rate in the United States	hFC = Annual Foreign Country Inflation Rate

Using the data above and textbook equation (18.3) E(S_t) = S₀ ∙ [1 + (h_FC - h_US)]^t and assuming the estimated inflation rate in Year 1 also holds for Years 2 and 3, please respond to the following:

Based on relative purchasing power parity, estimate S1. Based on relative purchasing power parity, estimate S2. Based on relative purchasing power parity, estimate S3. Based on relative purchasing power parity, has the foreign currency appreciated or depreciated against the US dollar? Explain. Based on relative purchasing power parity, has the NPV of the investment project increased or decreased in US dollar terms? Explain.

[1] Please note currencies are grouped according to their region: Americas (where the United States dollar may be found), Asia-Pacific, Europe, and MENA. Please advise your instructor should this or any other link in the assignment be broken.

[2] Sources of Inflation data include http://stats.oecd.org/ for OECD countries and http://data.worldbank.org/indicator/FP.CPI.TOTL.ZG at the World Bank site. It is viewed important to be consistent in the definition and source of inflation numbers for the US and the other currency that you use for the relative PPP equation. The most basic definitions of inflation are consumer price index (CPI), producer price index (PPI), and GDP deflator. Estimates of the next year’s inflation are preferred but it is also common to use the past year’s inflation as the best estimate of next year’s and subsequent years’ inflation. You are encouraged to share any useful websites for this data you find with the class.

Answer 1

Short-Run Exchange Rate Risk

Foreign Currency	Date	Current Spot Rate in European terms: FX per   1 US dollar	Six -Month Forward Rate in European terms: FX per 1 US dollar
Australian Dollar	9/22/2018	Spot Rate: 1.3721	Sell amount: AUD 1.37 Forward rate: AUD 1.3699

Qns. At the current spot rate, how much in the foreign currency are you owed in 6 months?

Ans: As the current spot rate is given as USD/AUS = 1.3721

It means it takes 1.3721 AUS dollars to buy 1 US dollar. So, if trade receivable is worth $5,000,000 in 6 months then you must be receiving the amount worth AUS $6,860,500 at the end of 6 months in terms of the Australian dollar with respect to current spot rate.

Assuming you fully hedge your FX exposure in the forward market, how many US dollars will you receive in 6 months?

Ans: As the forward rate after 6 months is: AUS 1.3699, then you would be getting US $ (5000000*1.3699)= US $6,849,500

Is the foreign currency selling in the forward market at a premium, i.e. it appreciates relative to the spot rate, or a discount, i.e., it depreciates relative to the spot rate? Provide numbers to support your answer.

Ans: Current spot rate is : AUS $1.3721,

It means it takes 1.3721 AUS dollars to buy 1 US Dollar

Forward rate is: AUS $ 1.3699

It means it will take 1.3699 AUS dollars to buy 1 US dollar after 6 months.

If we conclude the data, it will take less AUS dollars in future to buy 1 US dollar. Definitely, the foreign currency is appreciating in future with respect to US dollars.

Long-Run Exchange Rate Risk

S0 = Current Spot Rate in European Terms (Foreign currency per US dollar)	E(St) = Expected Exchange Rate Spot Rate in t Years in European Terms (Foreign currency per US dollar)	hUS= Annual Inflation Rate in the United States	hFC = Annual Foreign Country Inflation Rate
Foreign Currency: AUD Current spot rate: 1.3721	E(S1) = 1.3721(1+(0.019-0.021)^1 = 1.369 E(S2) = 1.3721(1+(0.019-0.021)^2 = 1.366 E(S3) = 1.3721(1+(0.019-0.021)^3 = 1.363	2.1	1.9

Note: Above data has been taken from OECD website.

Based on relative purchasing power parity, estimate S1.

E(S1) = 1.3721(1+(0.019-0.021)^1 = 1.369

Based on relative purchasing power parity, estimate S2.

E(S2) = 1.3721(1+(0.019-0.021)^2 = 1.366

Based on relative purchasing power parity, estimate S3.

E(S3) = 1.3721(1+(0.019-0.021)^3 = 1.363

Based on relative purchasing power parity, has the foreign currency appreciated or depreciated against the US dollar? Explain.

As the inflation rate in Australia is less than the inflation rate in the US. It takes less amount of Australian Dollars to buy 1 US dollar every year. It means the foreign currency is appreciating in its value with respect to US dollars.

Based on relative purchasing power parity, has the NPV of the investment project increased or decreased in US dollar terms? Explain.

As we found out, US dollar is depreciating and foreign currency is appreciating in their values. It means the NPV of the investment project will be decreased in Australia if the investment is made in terms of US dollars.