Question

Use the following information to answer the next two questions.

A bank manager believes the peso will appreciate relative to the peso in six months. The current spot rate for pesos is 10 pesos/euro and the six month forward rate is €.08/peso. The manager agrees to enter into a six month forward contract with 6 million pesos attached. The spot rate is 20 pesos/euro on the day the forward contract expires.Find the currency trader’s profit/loss (in euros) from their forward contract. Round intermediate steps to four decimals and your final answer to two decimals. Do not use currency symbols or words when entering your response.

QUESTION 2

Instead of using the forward contract, suppose the manager used the spot market to trade based on his belief. What would have been his profit/loss(in euros) at the end of the six month period?

		-60,000,000
		60,000,000
		-300,000
		300,000
		None of the above

Answer 1

Understanding the scenario-
The managers expectation was that the Peso will appreciate i.e. the rate will change from 10 pesos/ euro to a rate less than 10 peso/ euro. He enters into the trade with a similar expectation. The trade would be sell 6M Pesos now at 10 peso/ euro and buy back the peso at the end of 6 months. Suppose the 2 possible scenarios are as below-

peso	euro	rate peso/ euro	rate euro/ peso	Peso movement
6,000,000	600,000	10	0.1	base case
12,000,000	600,000	20	0.05	depreciate
3,000,000	600,000	5	0.2	appreciate

Actual scenario-
rate peso/ euro	rate euro/ peso
10	0.1	spot rate
12.5	0.08	forward rate
20	0.05	spot rate at expiry

Q1
Trade would be set up as follows-
1. enter into forward contract to buy the peso after 6 months at the contract rate of 12.5 peso/ euro
2. at the end of 6 months- pay (6,000,000/12.5)= 480,000 euro to purchase 6 M peso
3. sell the 6 M peso at the 6 months spot rate of 20 peso/ euro and receive (20* 480,000)= 9.6 M peso
4. profit from forward contract trade will be (9,600,000- 6,000,000)= 3.6 M peso or (3,600,000/20)= 180,000 euro

Q2
Trade would be set up as follows-
1. sell 6 M peso at spot and receive (6,000,000/10)= 600,000 euros at the current spot rate 10 peso/ euro
2. at the end of 6 months- buy back the pesos at the 6 months spot rate of 20 peso/ euro and receive (600,000*20)= 12,000,000 peso
3. the loss in the trade is 6 M (selling qty) - 12 M (purchase qty) = 6 M peso which is equal to (6,000,000/30)= 300,000 euros
4. the loss denominated in euro is 300,000 euro