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.

A) 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?

B) 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?

C) 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?

D) 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)

1.The pound will depreciate with respect to dollar .The currency of the country having high inflation depreciates in the value because the local goods become costly , so people in that prefer imported goods over local goods hence demand for foreign currency increases. on the other hand the goods manufactured in that country become costly so their demand in global market decreases , hence demand for local currency decreases. So the local currency depreciates because demand for local currency decreases and that for foreign currency increases.

2. Since Sports exports Inc. is exporter a depreciating pound would be favorable for Sports exports inc. For example :- If previously he received 1300 pound when exchange rate was 1.3 pound is to 1 dollar he would get 1000 dollars (1300/1.3) for 1300 pound. now  is exchange rate becomes 1.2 pound for 1 dollar he would get 1083 dollars (1300/1.2)

3.By using the currency futures, Sports exports Inc. can fix a particular rate at which the pounds can be exchanged for dollar in the future date .Since it is going to receive pound it should enter into the future contract to sell pound and receive dollar at a particular rate. Using currency futures could be disadvantageous if the the pound depreciates in the future of if the dollar appreciates.

4. Jim can buy call options to buy dollars.call option on dollars will give Jim the right to buy ( but not an obligation) dollar at a particular rate.The limitation of buying an option can be that if the spot rate is more favorable at the time of receives pounds than Sports Exports Inc. may exchange the pound directly in the market. That way he may not use the option and the amount of premium used to buy the option may go waste.

5. If the CNBC is incorrect then also there would be no issue.

B

1.The banks usually have a difference between the rate at which they buy a currency and the rate at which they sell the currency. This is called bid-ask spread ,which how the bank earns  profit in buying or selling a currency. For some banks it can be high for some banks it can be low. Hence he can search for a bank that may convert ponds in dollar at a more favorable rate . That is giving more dollars for the same amount of pound.

2. No, if it is the only bank in that then it may charger higher for converting pound into dollars. Hence it may give less dollar for the same amount of pound compared to other town's bank where the competition among banks is high.

3. Forward rate = spot rate (1+int rate in overseas country/1+int rate in domestic currency) = 1.35*(1.01/1.014)=1.34467. the bank offers 1.3435 pound for 1 dollar.Hence the rate of bank is proper.

C.

1. Yes Mr. Logan's interpretation of international fisher effect is correct. The theory does say that country of currency with higher interest rate will depreciate . And yes the result from hedging would be the same as that from not hedging.

2. If I were in Mr. logan's place I would hedge the currency because there could be some other reasons because of which the international fisher effect may not work. Hence if the cost of hedging is not high then, currency should be hedged.

D.