1. Forward contract/ transaction cost
On 1 January Importer Ltd arranges for a US supplier to deliver a consignment of goods costing
US$96,000 for which payment is due on 1 July. Importer Ltd thus arranges a forward contract
with its bank to buy US$96,000 in 6 months. In the event, the consignment is reduced and
Importer Ltd only requires US$50,000 to pay its supplier. The bank therefore agrees to close-
out the forward contract for US$46,000 that is not required.
(a) What is the cost to Importer Ltd of the whole transaction (ignoring commission)?
Bank sells US$96,000 to Importer Ltd at the 6 month forward offer rate at 1 January of
$1.5050 £63, 787.38
Bank purchases US$46,000 from Importer Ltd at the 1 July bid rate of $1.5110
£30,443.41
Cost to Importer Ltd = £33,343.97
(b) How might Importer Ltd reduce the costs of the transaction?
The transactions costs could have been reduced by Importer Ltd asking the US supplier to bill
in UK£s. This would have obviated the need to arrange a forward currency contract and so
avoid the translation risk (costs) associated with having to buy/sell US$ currency from/to the
bank. In practice, Importer Ltd would also incur bank charges (commission and administration
fees) in setting up the forward contract. However, if the US supplier were to invoice in UK £s
the currency risk would be borne by that firm. Clearly, the US supplier may be reluctant to do
this unless there were good business reasons (e.g., marketing considerations).
2. Offer-bid spot rate/ borrow/ deposit/ market hedge
A UK firm owes a Swedish firm SEK 3.5 million in 3 months. The current offer-bid spot rate is
SEK/£ 7.5509-7.5548. The UK firm can borrow £s for 3 months at 8.6% per annum and deposit
SEK for 3 months and receive 10% per annum.
(a) What is the cost in £s with a market hedge?
Interest rate to borrow in UK£s for 3 months is A% [= 8.6% * (3 months/ 12 months)] and
return on SEK deposits is B% [= 10% * (3 months/ 12 months)].
The UK firm therefore needs to deposit sufficient SEK to produce SEK 3.5 million in 3 months.
This means depositing SEK X [= SEK 3.5million / (100% + B%)]
At the current offer spot rate this will cost the UK firm £ Y [= X / 7.5509]
The UK firm must borrow this amount and at 3 months interest of A% it will have to repay:
= £Y * (100% + A%) = £Z
Z is the cost of the currency market hedge to the UK firm.
, (b) What is the effective forward rate?
= 3.5 million / Z
(c) Why engage in currency market hedging?
The idea behind a currency market hedge is that exchange rates and interest rates
are closely related. This leads some commentators to suggest that forex forecasts
based on the interest rate parity model provides the most reliable estimate. A
currency market hedge can be cheaper than a forward contract (e.g., in that it saves
commission and arrangement fees) and there can be scope for arbitrage benefits
because exchange and interest rates can vary between jurisdictions. Of course,
cross-national exchange and interest rates (to savers and borrowers) can change
substantially in short periods of time thus reducing opportunities for arbitrage.
Nonetheless, the paying fees and commissions might be worth considering on very
short forwards (of say 1 month or less). Another reason for a firm to engage in
money market hedging is that it might be easier (e.g., for organizational reasons) to
engage in lending/depositing in different countries than engage in the use of
derivatives (e.g., there may be corporate or regulatory restrictions on derivatives use
– as in the insurance sector).
3. Exchange rate/ purchasing parity/ end of year/ annual inflation/ PPP
If the exchange rate between the UK£ and Norwegian Kroner is £1/NKR 8 and
assuming purchasing parity so that an item costing £110 will cost NKR880, what is the
expected exchange rate at the end of the year from the perspective of a UK 'home'
trader, if annual inflation in Norway is predicted to be 5% and in the UK 8%?
→→→
This question tests the purchasing power parity model. This predicts that exchange
rates depend on the relative purchasing power of each currency in its own country
and that spot rates vary over time according to relative changes in domestic prices.
If we assume the perspective of a Norwegian trader then the PPP model is:
St = S0 x [(1+in) ÷ (1+iuk)]
Where St = forecast exchange rate;
S0 = current spot rate
in = expected inflation in 'foreign' country (Norway)
iuk = expected inflation in 'home' country (UK)
Therefore: St = 8 * (100% + 5%) : (100% + 8%) = A
UK price = £110 * (100% + 8%) = £B
Norwegian price = NKR 880 * (100% + 5%) = NKR C
St = C/B = A
On 1 January Importer Ltd arranges for a US supplier to deliver a consignment of goods costing
US$96,000 for which payment is due on 1 July. Importer Ltd thus arranges a forward contract
with its bank to buy US$96,000 in 6 months. In the event, the consignment is reduced and
Importer Ltd only requires US$50,000 to pay its supplier. The bank therefore agrees to close-
out the forward contract for US$46,000 that is not required.
(a) What is the cost to Importer Ltd of the whole transaction (ignoring commission)?
Bank sells US$96,000 to Importer Ltd at the 6 month forward offer rate at 1 January of
$1.5050 £63, 787.38
Bank purchases US$46,000 from Importer Ltd at the 1 July bid rate of $1.5110
£30,443.41
Cost to Importer Ltd = £33,343.97
(b) How might Importer Ltd reduce the costs of the transaction?
The transactions costs could have been reduced by Importer Ltd asking the US supplier to bill
in UK£s. This would have obviated the need to arrange a forward currency contract and so
avoid the translation risk (costs) associated with having to buy/sell US$ currency from/to the
bank. In practice, Importer Ltd would also incur bank charges (commission and administration
fees) in setting up the forward contract. However, if the US supplier were to invoice in UK £s
the currency risk would be borne by that firm. Clearly, the US supplier may be reluctant to do
this unless there were good business reasons (e.g., marketing considerations).
2. Offer-bid spot rate/ borrow/ deposit/ market hedge
A UK firm owes a Swedish firm SEK 3.5 million in 3 months. The current offer-bid spot rate is
SEK/£ 7.5509-7.5548. The UK firm can borrow £s for 3 months at 8.6% per annum and deposit
SEK for 3 months and receive 10% per annum.
(a) What is the cost in £s with a market hedge?
Interest rate to borrow in UK£s for 3 months is A% [= 8.6% * (3 months/ 12 months)] and
return on SEK deposits is B% [= 10% * (3 months/ 12 months)].
The UK firm therefore needs to deposit sufficient SEK to produce SEK 3.5 million in 3 months.
This means depositing SEK X [= SEK 3.5million / (100% + B%)]
At the current offer spot rate this will cost the UK firm £ Y [= X / 7.5509]
The UK firm must borrow this amount and at 3 months interest of A% it will have to repay:
= £Y * (100% + A%) = £Z
Z is the cost of the currency market hedge to the UK firm.
, (b) What is the effective forward rate?
= 3.5 million / Z
(c) Why engage in currency market hedging?
The idea behind a currency market hedge is that exchange rates and interest rates
are closely related. This leads some commentators to suggest that forex forecasts
based on the interest rate parity model provides the most reliable estimate. A
currency market hedge can be cheaper than a forward contract (e.g., in that it saves
commission and arrangement fees) and there can be scope for arbitrage benefits
because exchange and interest rates can vary between jurisdictions. Of course,
cross-national exchange and interest rates (to savers and borrowers) can change
substantially in short periods of time thus reducing opportunities for arbitrage.
Nonetheless, the paying fees and commissions might be worth considering on very
short forwards (of say 1 month or less). Another reason for a firm to engage in
money market hedging is that it might be easier (e.g., for organizational reasons) to
engage in lending/depositing in different countries than engage in the use of
derivatives (e.g., there may be corporate or regulatory restrictions on derivatives use
– as in the insurance sector).
3. Exchange rate/ purchasing parity/ end of year/ annual inflation/ PPP
If the exchange rate between the UK£ and Norwegian Kroner is £1/NKR 8 and
assuming purchasing parity so that an item costing £110 will cost NKR880, what is the
expected exchange rate at the end of the year from the perspective of a UK 'home'
trader, if annual inflation in Norway is predicted to be 5% and in the UK 8%?
→→→
This question tests the purchasing power parity model. This predicts that exchange
rates depend on the relative purchasing power of each currency in its own country
and that spot rates vary over time according to relative changes in domestic prices.
If we assume the perspective of a Norwegian trader then the PPP model is:
St = S0 x [(1+in) ÷ (1+iuk)]
Where St = forecast exchange rate;
S0 = current spot rate
in = expected inflation in 'foreign' country (Norway)
iuk = expected inflation in 'home' country (UK)
Therefore: St = 8 * (100% + 5%) : (100% + 8%) = A
UK price = £110 * (100% + 8%) = £B
Norwegian price = NKR 880 * (100% + 5%) = NKR C
St = C/B = A
