Question

A manager of a corporation based in U.S. is expecting to receive 1,000,000 UK pounds in 1 year from corporation’s UK client.At that time the manager is planning to exchange UK pounds for US dollars. Current market rates are as follows: U.S. 1-yearinterest rate is 6% per annum, UK 1-year interest rate is 4.5% per annum, the spot price of UK pound is $1.55, the forwardprice of UK pound is $1.56. Assume discrete compounding.

1. What is the synthetic forward price of UK pound? (11 pts)

2. Given the rates above what should the manager’s actions be if the goal is to lock-in future US dollar revenue at thebest possible exchange rate? Describe the strategy in detail, show your calculations. (12 pts)

Answer 1

If currency is hedged using money market, the forward price we get is synthetic forward price.

Synthetic Forward Price = Spot price x (1+quoted currency interest rate) / (1+base currency interest rate)

Synthetic Forward Price = $1.55 x (1+6%) / (1+4.5%)

Synthetic Forward Price = $1.57225

Actual Forward Rate = $1.56

Manager should use synthetic forward price that is money market hedge to hedge the excepted receipt from UK.

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