2. Consider the following information for the U.K. and the U.S: U.K. inflation rate (annual) &

2. Consider the following information for the U.K. and the U.S:
U.K. inflation rate   (annual)                               3.56%
U.S. inflation rate                                               1.95%
GBP/USD spot rate                                          1.3079
6-month GBP Eurodollar deposit rate               0.9131%
6-month USD Eurodollar deposit rate               2.83%
Sept. futures rate on the CBOE                        1.3234
Premium for a Sept 1.32 call                             0.05
Premium for a Sept 1.32 put                             0.06
a. What do you expect will be the GBP/USD exchange rate in 6-months?
b. Suppose you will receive 100,000 GBP in 6-months. Should you hedge? Which is the best way (forward, future, money market, or option) to hedge?
c. If you will pay 100,000 in 6-months, should you hedge? Again which is the best hedge? In both scenarios take Brexit into account.

Expert Solution

a. What do you expect will be the GBP/USD exchange rate in 6-months?

Let's use the concept of Fischer interest rate parity.

Spot rate, S₀ (GBP / USD) = 1.3079 to be interpreted as 1 GBP = 1.3079 USD

6-month GBP Eurodollar deposit rate = I_GBP = 0.9131%
6-month USD Eurodollar deposit rate = I_USD = 2.83%

T = 6 months = 6/12 = 0.5 year

Hence 6 months forward rate, F (GBP / USD) = S₀ x (1 + I_GBP)^T / (1 + I_USD)^T = 1.3079 x (1 + 0.9131%)^0.5 / (1 + 2.83%)^0.5

Hence, 6 months forward rate (GBP / USD) = 1.2957 to be interpreted as 1 GBP = 1.2957 USD

b. Suppose you will receive 100,000 GBP in 6-months. Should you hedge? Which is the best way (forward, future, money market, or option) to hedge?

September future rate = 1.3234 i.e. 1 GBP = 1.3234 USD

Since this rate is better than the expected 6 months forward rate, it's better to lock in the exchange rate corresponding to September future rate today. Hence, we will hedge.

Forward, future, money market and option - all are possible instruments for hedging. Best way to hedge is using futures or forwards.

Money market hedging involves multiple steps and transaction costs associated are high. For a large corporate, this may not be an effective choice.

c. If you will pay 100,000 in 6-months, should you hedge? Again which is the best hedge? In both scenarios take Brexit into account.

If there is a foreign currency payments to be made and you want to prevent yourself from fluctuations in exchange rate, we should hedge. Against hedging is possible through various options, but the best way to hedge is futures of forward contracts.

jeff jeffy answered 1 year ago

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2. Consider the following information for the U.K. and the U.S: U.K. inflation rate (annual) &

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