Question

1-Assume that a currency’s spot and futures price are the same, and the currency’s interest rate is higher than the U.S. rate. If US investors wish to lock in the higher foreign return (and limit risk), what effect will the actions of U.S. investors have on the currency’s spot rate? the currency’s futures price?

2- Your company expects to receive 5,000,000 Japanese yen 60 days from now. You decide to hedge your position by selling Japanese yen forward. The current spot rate of the yen is $.0089, while the forward rate is $.0095. You expect the spot rate in 60 days to be $.0090. How many dollars will you receive for the 5,000,000 yen 60 days from now?

Answer 1

1. Following is the scenario given :

• Currency's spot rate = future rate
• Currency's interest rate > US interest rate
• Investor locks in the higher foreign return and limits the risk (which means that investors enters a forward contract)

In order to lock the higher foreign return, he/she will have to sell the dollar and buy the foreign currency. Hence, the spot rate of the foreign currency will appreciate as compared to the US Dollar

However, future price of the foreign currency will fall (all else being equal). This is because after the investment period, the investors will sell the foreign currency and buy dollars.

In simple terms, price of a currency increases when it is bought and vice-versa

2. Following is the scenario given :

• Company expects to receive 5,000,000 Japanese yen in 60 days
• Company decides to enter into a forward contract to hedge the position (sell yen and buy dollars at the forward rate)

The forward rate = $0.0095 (it means that 1 yen = $0.0095)

Hence, the company will receive (5,000,000 x 0.0095) = $47,500

Note : In the given question, three rates are provided - spot rate, forward rate and expected spot rate after 60 days

• Present spot rate is irrelevant since the company will receive the money after 60 days
• Expected spot rate is also irrelevant from cash receipt point of view, as the company has entered into forward contract.