Question

3. One component of learning about another country or region is to understand the relationship of its currency with others on the world currency market. As such, you are assigned the duty of ensuring the availability of 100,000 yen for a payment scheduled next month. Considering that your company possesses only U.S. dollars, identify the spot and forward exchange rates. What are the factors that influence your decision to use each? Which one would you choose? How many dollars must you spend to acquire the amount of yen required?

Answer 1

The Spot exchange rate is the current exchange rate between two currency. This rate is used for immediate transaction of goods and services across borders. The forward rate is exchange rate is the exchange rate between two currency at a prespecified date in a contract. The forward exchange rate can be calculates as

Here F is forward exchange rate, S is spot exchange rate, id is domestic interest rate anf if is foreign exchange rate.

The spot exchange rate between Yen and dollar is : 112.36 yen/dollar

The Forward exchange rate between Yen and dollar is : 112.17 yen/dollar

To choose either of the rate the time frame must be keep in mind. As the transaction is cariied out 1 month from now, the rate that should be chosen is 1 month forward exchange rate. The changes in interest rate and real return and the time at which the transaction is cariied out must be considered as changes in any of these can cause loss for the firm. Both of these rates are calculated keeping the interest rate parity in mind and to deter unnecessary hedging of funds. Then the value of 100000 yen or 890 USD is equal to 891.5 USD 1 month from now if the oppertunity cost of keeping the 890 USD in other financial assets.

Using forward exchange rate the 100,000 yen will cost 891.5 USD.