Question

Consider the following data:-

GBP/USD spot : 1.7500/10

GBP/USD 3m fwd : 1.7380/1.7400

3months dollar interest rate = 8.1%

3 months pound sterling interest rate = 11%

A British firm has a 3 month dollar receivable of USD 500,000. The 2 options available to the firm are:-

1. Cover the receivable in the forward market

2. Borrow in dollars today and convert it to pounds in the spot market. Invest the pounds in the local market for 3 months. The receivables in dollars can be used to repay the dollar loan after 3 months.

What is the British company’s receivable under both the options. Which option would he go for. WHY?

Answer 1

When using forward market:

GBP/USD 3m fwd : 1.7380/1.7400; this quote means the units of dollar you get per unit of pound

Since we are to go long on a forward contract, we have to take the ask quote ie 1.7400USD/GBP

Payment received after 3 months = USD 500,000

Therefore equivalent amount in GBP = USD 500,000 * 1/(1.7400USD/GBP) = GBP 287,356.32

Borrow in dollars today and convert it to pounds in the spot market

Amount receivable after 3 months = USD 500,000

3 month Interest rates in USD = 8.1%

Therefore the amount we should borrow right now in USD = USD 500,000/(1+8.1%*3/12) = USD 490,075.96

(This amount in USD which we borrow today will be settled by the USD500,000 we receive after 3 months)

Converting USD 490,075.96 to GBP at spot rate: since we are buying GBP we will have to use ask spot rate

GBP/USD spot : 1.7500/10

GBP/USD ask spot rate = 1.7510

Amount in GBP = USD 490,075.96 * 1/(1.7510 USD/GBP) = GBP 279,883.47

Investing the above GBP amount @ 11% for 3 months

Amount received after 3 months = GBP 279,883.47 * (1 + 11%*3/12) = GBP 287,580.27

Since the amount in GBP received in this case is higher, we should go with this plan & not go with forward contract