Question

Forwards vs Futures (10 points) State the main differences between the Forwards contract and Futures contract. Arbitrage (20 points) Suppose the spot rate of the pound today is $1.70 and the three-month forward rate is $1.75 1. (10 points) How can a U.S. importer who has to pay 20,000 pounds in three months hedge her foreign exchange risk? 2. (10 points) What occurs if the U.S. importer does not hedge and the spot rate of the pound in three months is $1.80?

Answer 1

1)a forward contract is a contract between two parties to buy and sell the stated contracts at a specified rate in a future date. its price is negotiated between the buyer and the seller. there is no secondary market involved in trading. only the buyer and seller are involved in this. there is a maturity date that is a specific date that is determined at the beginning of the contract and the buyer and the seller trade on that maturity. its a high risk bearing trade because the market rate fluctuates frequently. there is no collateral required here only an aggrement paper does the job. and the size of the contract depends on the contract terms.

on the other hand a future contract is a more standardised verson of forward contract. here two party agrees to exchange financial asset at some specific price at a specific date in future. they exchange it for cash. it is being traded in an organised stock exchange, and the price fluctuates on a daily basis. its a less risky asset as compared to forward contract. here size of contract is fixed and it requires some initial margin. its a highly liquid asset as compared to forward one.

2) if the spot rate of the pound today is 1.70$ and the importer has to pay 20000 pound then in terms of dollar it would be 34000 approx.but if the person pays according to 3 month forward rate then it will be 35000 as the rate would be 1.75$ per pound. by hedging here the person can eliminate the foreign exchange risk.

if the us importer doesnot hedge he will have to pay 36000 dollar according to the new exchange rate i.e 1.80$ per pound.