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1. The current spot rate for dollar/euro is $/Euro 2.0000 +/- 0.003. The dollar is quoted at a 0.2c premium for the forward rate. What will a $2000 receipt be translated to at the forward rate?
Why does have to take 2.0000 + 0.003 – 0.002 = 2.01 to be spot rate? And why not taking 2.0000 – 0.0003 + 0.002?
2. A US company owes a European company euro 3.5m due to be paid in 3 months time. The spot exchange rate is $1.96-$2 : euro1. Annual interest rates in the two locations are as follows: US : Borrow rate 8%, Deposit rate 3% Europe : Borrow rate 5%, Deposit rate 1%. What will be the equivalent US $value of the payment using a money market hedge?
Firstly US Borrow rate of 8% and Europe Deposit rate of 1% will be used.
Euro3.5m / 1.0025 = Euro3.491m
Euro3.491m x 1.02 = Euro3.561m
Now we have to change back to dollar currency, so
Euro3.561m / $1.92 (spot rate) = $1.854m ( why is this wrong?)Answer sheet: Euro3.561 x $2 = $7.122 ( I don’t understand why do I have to multiply by $2 and not divide by $1.92)
Hi, as I am also revising the currency risk management, please allow me express my opinion here:
1.
+ We convert USD > EUR, which mean we sell USD, buy EUR. The logic is, when you sell USD, you will get “expensive” EUR (fewer EUR), therefore, the EUR amount received would be USD Amount divides for the “bigger” rate. That’s why we use 2.000 + 0.003.
+ Dollar is quoted @ 0.2c premium: premium means dollar is going to be stronger in future. The logic is, USD is going stronger, it means that more EUR you will receive when selling USD. As EUR Amount = USD amount / Ex.Rate, the Ex.Rate in future must be smaller than Spot Rate. That’s why we use 2.000 + 0.003 but – 0.002.
2.
+ I think you are mistake between multiplying and dividing. The thumb rule is, EUR is stronger than USD then 3.5m EUR must be converted to a “bigger” USD amount. Therefore, multiplying is applied here not dividing.Hi Binh, thanks for replying. I would like to clarify further for the 2 Qns.
2. The spot rate of $1.96-$2 : euro1. Therefore $1.96 (bank’s buying rate) and $2 (bank’s selling rate). So since the US company is owing money to an European company. It is right for the US company to borrow its own currency, therefore why I can’t I take
Euro3.561 x $1.96, instead of (x$2)1. You said ” the Ex.Rate in future must be smaller than Spot Rate”, are you referring the spot rate to be 2.000 + 0.003 = 2.003?
Binh: Please do not answer in this forum – it is the Ask the Tutor Forum and you are not the tutor 🙂
By all means ask questions here, or answer questions in the other P4 forum.Harold:
First question:
You really should watch the free lectures on foreign exchange risk management. You cannot expect me to type out all of the lectures here 🙂
When forward rates are quoted at a premium then we always subtract the premium (or if it is quoted at a discount then we add the discount). It may seem odd, but quoting a currency at a premium means that we expect the currency to strengthen and therefore the exchange rate as against the other currency will be lower.
Second question:
Again, you really must watch the free lectures. In the first lecture on foreign exchange risk I spend time explaining which rate to use and why.
In order to put Euros on deposit the company needs to buy Euros today. If they are buying Euros then they will have to pay $2 per Euro. (How could it possibly be the lower rate – it is the bank that makes the profit by quoting a spread, and not us).
Again – why have you not watched the lectures? They do not cost anything and they cover the entire syllabus 🙂
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