Suppose today’s exchange rate is $0.62/Euro. The 6-month interest rates on dollars and Euro are 6% and 3%, respectively. The 6-month forward rate is $0.6185. A foreign exchange advisory service has predicted that the Euro will appreciate to $0.64 within six months.
- How would you use forward contracts to profit in the above situation?
How would you use money market instruments (borrowing and lending) to profit?
Which alternatives (forward contracts or money market instruments) would you prefer? Why?
- How would you use forward contracts to profit in the above situation?
Answer. By buying Euro forward for six months and selling it in the spot market, you can lock in an expected profit of $0.0215 (0.64 – 0.6185) per Euro bought forward. This is a semiannual percentage return of 3.48% (0.0215/0.6185). Whether this profit materializes depends on the accuracy of the advisory service’s forecast.
- How would you use money market instruments (borrowing and lending) to profit?
Answer. By borrowing dollars at 6% (3% semiannually), converting them to Euro in the spot market, investing the Euro at 3% (1.5% semiannually), selling the Euro proceeds at an expected price of $0.64/Euro, and repaying the dollar loan, you will earn an expected semiannual return of 1.77%:
Return per dollar borrowed = (1/0.62) x 1.015 x 0.64 – 1.03 = 1.77%
- Which alternatives (forward contracts or money market instruments) would you prefer? Why?
Answer. The return per dollar in the forward market is substantially higher than the return using the money market speculation. Other things being equal, therefore, the forward market speculation would be preferred.
