Question

Scenario 1:

You have to estimate the expected exchange rates between your home currency and the other currencies of the major other countries that you deal with in terms of both imports and exports. The reason is that increases in the values of other currencies compared to the U.S. Dollar may impact your imports negatively, whilst it may on the other hand, be good for exports. To do this estimate, you obtain the following spot exchange rate information:

£/$	0.76918
AUD$/$	1.38140

You also obtain the following annual risk free rates applying in the countries:

U.S.A.	2.660%
Britain	0.778%
Australia	1.953%

Your focus is presently to estimate the 3 month forward rates in order to consider the impact that it will have on the import and export sales of the company. Calculate the forward rates of the $ in terms of all the currencies by using simple interest rate parity e.g. 10% annual interest rate = 10/2 = 5% for six months. Do not effective annual interest rate compounding. Show all your workings in table 1 on the separate answer sheet by using the correct formula provided in your formula sheet.

Provide an indication about what will happen to the value of the US$ based on the forward exchange rate calculations by calculating the expected discount/premium of it for each of the currencies in Table 2 on the separate answer sheet. Also show whether the impact will be positive (P) or negative (N) for imports and exports. For example:

Exchange rate	% Discount/Premium	Import	Export
£/$	Workings by you ……………. = 1.93% premium	Positive	Negative

Exchange rate	% Discount/Premium (Show calculations with answer). Answer must be rounded to 2 decimals. (1 mark each)	State whether positive or negative for imports (1 mark each)	State whether positive or negative for exports (1 mark each)
£/$	(0.76558 - 0.76918 / 0.76918)*100*12/3 = 1.87% (Discount)? or (0.76558 - 0.76918 / 0.76918) = 0.47%?	Negative	Positive
AUD$/$	(1.37898 - 1.3814 / 1.3814)*100*12/3 = 0.70% (Discount)? or (1.37898 - 1.3814 / 1.3814) =0.17%	Negative	positive

Answer 1

Computation of forward rate for Dollor and Pound

Spot rate: 1 $ = 0.76918 Pounds

calculation of Forward rate

Interest in U.S.A = 2.660%

Interest rate in Britain = 0.778%

By applying the above interest rate on the above spot rate, we get the forward rate

1 $ = 0.76918 Pounds

1$ + 2.660% *3/12*1 = 0.76918 pounds+0.76918*0.778%*3/12

1 $ +$ 0.00665 = 0.76918 pounds + 0.001496 pounds

$ 1.00665 = 0.770676 pounds

$ 1 = 0.770676 pounds/$ 1.00665

$ 1 = 0.76558 pounds

Earlier spot rate : 1 $ = 0.76918 Pounds,

But the forward rate: 1 $ = 0.76558 pounds

By looking at the spot and forward rates we can conclude that purchasing power of the USD is gradually decreasing. The Dollar is trading at a discount in the forward market.

Discount ( % ) = (0.76558-0.76918)/0.76918*12/3*100

= 1.87% Discount. Or

= 1.87%/12*3=0.46% for 3 months

If the USD ( Home currency ) is decling, then it will have a positive impact on the Exporters, sinnce theey are getting a foreign cash inflows whose value is high , when converted into home currency and it is having a negative impact on the importers since they are required to pay more dollors to purchase the pound.

Computation of forward rate for USD and Australian Dollar:

Spot rate: 1 $ = 1.38140 AUD

calculation of Forward rate

Interest in U.S.A = 2.660%

Interest rate in Australia = 1.953%

By applying the above interest rate on the above spot rate, we get the forward rate

1 $ = 1.38140 AUD

1$ + 2.660% *3/12*1 = 1.38140AUD+1.38140*1.953%*3/12

1 $ +$ 0.00665 = 1.38140AUD+0.006744 AUD

$ 1.00665 = 1.388144 AUD

$ 1 = 1.388144AUD/$ 1.00665

$ 1 = 1.378973 AUD

Earlier spot rate : 1 $ = 1.38140 AUD

But the forward rate: 1 $ = 1.37898 AUD

By looking at the spot and forward rates we can conclude that purchasing power of the USD is gradually decreasing. The Dollar is trading at a discount in the forward market.

Discount ( % ) = (1.37898-1.38140)/1.38140*12/3*100

= 0.70% Discount

= 0.70% /12*3 months= 0.17% for 3 months

If the USD ( Home currency ) is decling, then it will have a positive impact on the Exporters, sinnce theey are getting a foreign cash inflows whose value is high , when converted into homee currency.

And it is having a negative impact on the importers since they are required to pay more dollors to purchase the pound.

Summarizing the above information in a table forrm

Spot rate	Forward rate	Discount/Premium	Effect on importers	Eeffect on Exporters
1 USD = 0.76918 pounds	1 USD = 0.76558 pounds	1.87 % Discount	Negative	Positive
I USD = 1.38140 AUD	I USD = 1.37897 AUD	0.70% Discount	Negative	Positive