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Dear Sir,
I am Practicing Q2 of the December 2012 exam. There is one part that has me confused a bit and hoping for your assistance in figuring out the steps taken for calculating the Forward rate to be used for Case one.
Case One
Lignum Co regularly trades with companies based in Zuhait, a small country in South America whose currency is the Zupesos (ZP). It recently sold machinery for ZP140 million, which it is about to deliver to a company based there. It is expecting full payment for the machinery in four months. Although there are no exchange traded derivative products available for the Zupesos, Medes Bank has offered Lignum Co a choice of two over-the-counter derivative products.The first derivative product is an over-the-counter forward rate determined on the basis of the Zuhait base rate of 8·5% plus 25 basis points and the French base rate of 2·2% less 30 basis points.
Alternatively, with the second derivative product Lignum Co can purchase either Euro call or put options from Medes Bank at an exercise price equivalent to the current spot exchange rate of ZP142 per €1. The option premiums offered are: ZP7 per €1 for the call option or ZP5 per €1 for the put option.
The premium cost is payable in full at the commencement of the option contract. Lignum Co can borrow money at the base rate plus 150 basis points and invest money at the base rate minus 100 basis points in France.
The formula for the forward rate is given on the formula sheet ( the interest rate parity formula).
The Zuhait interest rate to use is 8.5% + 0.25% = 8.75% per year, or 8.75 x 4/12 = 2.91667% for 4 months.
The French rate to use is 2.2% – 0.30% = 1.9% per year, or 1.9 x 4/12 = 0.6333% for 4 monthsTherefore the forward rate = 142 (spot rate) x 1.0291667 / 1.006333 = 145.23
I am seeking some clarity in regards to how find a 4 month forward exchange rate when given a 3 mnth forward and a 1 year forward.
POLYTOT PLC
Assume that it is now 1 July. Polytot plc has received an export order valued at 675 million
pesos from a company in Grobbia, a country that has recently been accepted into the
World Trade Organisation, but that does not yet have a freely convertible currency.
The Grobbian company only has access to sufficient $US to pay for 60% of the goods, at the
official $US exchange rate. The balance would be payable in the local currency, the
Grobbian peso, for which there is no official foreign exchange market. Polytot is due to
receive payment in four months’ time and has been informed that an unofficial market in
Grobbian pesos exists in which the peso can be converted into pounds. The exchange rate
in this market is 15% worse for Polytot than the ‘official’ rate of exchange between the
peso and the pound.Exchange rates:
$/£
Spot 1.5475–1.5510
3 months forward 1.5362–1.5398
1 year forward 1.5140–1.5178I assume you have looked at the printed answer to this?
We interpolate between the 3 month and 12 month forward rates.
So, looking at the lower rates, they change by 1.5362 – 1.5140 = 0.0222 over a period of 9 months. So the change per month = 0.0222 / 9 = 0.0025
The 4 month forward rate will be the 3 month forward rate changed by 1 month.
So the 4 month rate = 1.5362 – 0.0025 = 1.5337 (obviously it is lower than the 3 month rate because the 12 month rate is lower).
Estimating the higher rates is done in exactly the same way, using 1.5398 and 1.5178
I am looking at the answers but im just confused, here is another question and the related answer
Lammer plc is a UK-based company that regularly trades with companies in the USA.
Several large transactions are due in five months’ time. These are shown below. The
transactions are in ‘000’ units of the currencies shown.Assume that it is now 1 June and that futures and options contracts mature at the
relevant month end.Exports to: Imports from:
Company 1 $490 £150
Company 2 – $890
Company 3 £110 $750Exchange rates: $US/£
Spot 1.9156–1.9210
3 months forward 1.9066–1.9120
1 year forward 1.8901–1.8945Answer
Forward market hedge:
No five-month forward rate is given. The rate may be interpolated from the three-month
And one-year rates for buying dollars.The estimated five-month forward rate is:
1.9066 x 7/9 + 1.8901×2/9 = 1.9029
1,150,000/1.9029= 604,341I used the same approach as this for Polytot but did not get the same answer
I used your suggested answer with the Lammer Question and got the correct answer. The method used in Lammer plc is confusing. Not understanding why they use the numerators 7 & 2
2 is because 5 months is 2 months away from 3 months, and 7 is because 5 months is 7 months away from 12 months!! (Sorry – it is difficult to write in a different way 🙂 )
Either way will always work (and it doesn’t matter which way you do it in the exam). I would always do it the same way as in Polytot, but it is whichever you find the easier 🙂
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