Question

Scenario: Jim Logan, the owner of an American based small business, Sports Exports, Inc., specializes in exporting footballs to Great Britain. In return, he receives payments in British pounds every month which need to be converted into dollars. He has noticed that the exchange rate between the dollar and the pound at the time of exchange every month is significantly affecting his profits. Since he is a small business owner and not a foreign currency expert, he has hired your consulting firm to advise him with respect to the following matters below.

1. Jim Logan recently heard on CNBC that inflation is expected to rise substantially in the United Kingdom, while inflation in the United States will remain low. They also expect that the interest rates in both countries will rise by about the same amount. He asks you to answer the following questions so that he may take the appropriate measures if CNBC is correct in their projections.
   1. From an economic perspective, will the pound appreciate or depreciate against the dollar and explain why?
   2. Will Sports Exports, Inc. be favorably or unfavorably affected by the future changes and explain why?
   3. How can Sports Exports, Inc. use currency futures contracts to hedge against exchange rate risk? Are there any limitations of using currency futures contracts that would prevent Sports Exports, Inc. from locking in a specific exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months?
   4. How can Sports Exports, Inc. use currency options contracts to hedge against exchange rate risk? Are there any limitations of using currency futures contracts that would prevent Sports Exports, Inc. from locking in a specific exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months?
   5. While Mr. Logan believes the CNBC report, he would also like to know what to do if CBNC is incorrect specifically with respect to using futures or options to hedge the exchange rate risk in this opposing scenario? Are there any disadvantages in this scenario?

2. The check (denominated in pounds) for last month’s exports just arrived. Mr. Logan normally deposits the check with his local bank and requests that the bank convert the check to dollars at the prevailing spot rate (assuming that he did not use a forward contract to hedge this payment). Logan’s local bank provides foreign exchange services for many of its business customers who need to buy or sell widely traded currencies. Today, however, Logan decided to check the quotations of the spot rate at other banks before converting the payment into dollars.
   1. Mr. Logan wants to know whether your firm thinks that this is a worthwhile thing for him to do so. Specifically, will he be able to find a bank to provide him with a more favorable spot rate than his local bank? Explain?
   2. Do you think that Mr. Logan’s bank is likely to provide more reasonable quotations for the spot rate of the British pound if it is the only bank in town that provides foreign exchange services? Explain?
   3. Logan is also considering using a forward contract to hedge the anticipated receivables in pounds next month. His local bank quoted him a spot rate of $1.35 and a 1-month forward rate of $1.3435. Before he decides to sell pounds 1 month forward, he wants to be sure that the forward rate is reasonable, given the prevailing spot rate. A 1-month Treasury security in the U.S. currently offers a yield (not annualized) of 1%, while a 1-month Treasury security in the U.K. offers a yield of 1.4%. Does your firm believe that the 1-month forward rate is reasonable given the spot rate of $1.35?

3. Now, Mr. Logan is questioning whether this process is worth the trouble. He suggests that if the international Fisher effect (IFE) holds, the pound’s value should change (on average) by an amount that reflects the differential between the interest rates of the two countries of concern. Because the forward premium reflects the same interest rate differential, the results from hedging should equal the results from not hedging on average.
   1. Is Logan’s interpretation of the IFE theory correct? Why?
   2. If you were in Logan’s position, would you spend time trying to decide whether to hedge the receivables each month, or do you believe that the results would be the same (on average) whether you hedge or not?

4. Mr. Logan expects that British inflation will rise substantially in the future. In previous years when the British inflation was high, the pound depreciated. The prevailing British interest rate is slightly higher than the prevailing U.S. interest rate. The pound has risen slightly over each of the last several months. Mr. Logan wants you to forecast the value of the pound for each of the next 20 months. You explain to him that this will result in an additional fee, but that your firm will explain how the extra service would work?
   1. Explain how you can use technical forecasting to forecast the future value of the pound. Based on the information provided, do you think that a technical forecast will predict future appreciation or depreciation in the pound?
   2. Explain how you can use fundamental forecasting to forecast the future value of the pound. Based on the information provided, do you think that a technical forecast will predict future appreciation or depreciation in the pound?
   3. Explain how you can use market-based forecasting to forecast the future value of the pound. Based on the information provided, do you think that a technical forecast will predict future appreciation or depreciation in the pound?
   4. Does it appear that all of the forecasting techniques will lead to the same forecast of the pound’s future value? Which technique would you prefer to use in this situation?

Answer 1

A)

Part one - According to CNBC the inflation is expected to rise substantially in UK while inflation will be low in USA. This will lead to an increase of interest rates in UK in comparison to USA. Since UK provides higher interest rates on invested funds in comparison to USA, UK will attract more foreign capital and UK currency will be purchased more leading to the appreciation of UK currency in comparison to USA currency. Hence pound being UK currency will appreciate.

Part two -  Sports Exports, Inc. will be favorably affected by the appreciation since the same amount of Pound converted to Dollar will bring in more dollars as compared to non appreciated pound.

Part three - Sports Exports, Inc. can use currency futures contracts to lock in a future rate whereby it can agree with a counter-party to sell pound and receive dollar at an agreed future conversion rate or also enter into a contract to exchange a fixed amount of pound for dollar at a future date . If Sports Exports, Inc. decides to use currency futures to hedge the foreign currency risk, it may face a situation where more pounds are received than hedged using the futures, whereby Sports Exports, Inc. may have to convert the extra pound to dollar at an unfavorable rate. Also if the pound further appreciates in comparison to dollar in comparison to the locked in futures conversion rate the company might loose a chance to profit on the extra appreciated pound - this is opportunity cost.

Part four - If CNBC is incorrect Mr. Logan can either buy a put option which is a option not a commitment to exchange pound to receive dollar at exercise exchange rate if the exchange rate falls below the exercise rate. since downside potential is completely hedged no such limitations apart from the point that at-the-money options are expensive than out-of-money options and trade-off between cost and benefit shall be considered before buying puts.

Currency future can also be used where no cash is exchanged at initiation and a conversion price is locked at future date. the currency future is a commitment and hence has to be exercised. The upside potential of particular appreciation is lost.