Suppose that the current Bid-Offer on the Euro is $1.21/E and $1.23/E, and the t

Question

Suppose that the current Bid-Offer on the Euro is $1.21/E and $1.23/E, and the three-month forward is $1.185/E.

1. If you wish to hedge 100,000 Euro Revenue due in three months, what position would you take? Explain why.
a. Buy Euro forward at $1.23/E
b. Buy dollars forward at $1.23/E
c. Sell Euro forward at $1.185/E
d. Sell dollars forward at $1.21/E
e. Buy Euro forward at $1.185/E


2. If the Bid-Offer at maturity is $1.17/E and $1.19/E (assume the bank is following the same quote convention), have you made or lost money by hedging, and how much have you made or lost? Explain why.
a. Loss < $1200
b. Loss > $1200
c. Profit 500 E
d. Profit < $1200
e. Profit > $1200

3. If the average of the Bid-Offer is the spot, which currency is expected to depreciate, and by how much, over the three months? Show your work.

a. Dollar, < 3%
b. Dollar, > 3%
c. Euro, < 3%
d. Euro, > 3%
e. No depreciation


4. If the average of the Bid-Offer is the spot, which currency is depreciated and what was the realized depreciation over the three months? Show your work.

a. Dollar, < 2%
b. Dollar, > 2%
c. Euro, < 2%
d. Euro, > 2%
e. No depreciation

Explanation / Answer

1. Since you wish to hedge the revenue received in Euros, you would lock in the $:E exchange rate by buying euro forward at the forward rate of $1.185/E which would give you dollars in exchange for euros. Hence the answer is e. 2. At maturity, the bid rate on euro is $1.17/E which is lower than the forward rate of $1.185/E. Hence you have made a profit of (1.185 - 1.17) * 100,000 = $60,000. Answer is e. 3. Current spot rate = (1.21 + 1.23)/2 = $1.22/E The forward rate is $1.185/E which is lower than the current spot rate. Hence the Euro is expected to depreciate by (1.22 - 1.185) / 1.22 = 2.87%. Answer is c. 4. Spot rate at maturity = (1.17 + 1.19)/2 = $1.18/E, which is lower than the initial spot rate of $1.22/E. The Euro depreciated by (1.22 - 1.18) / 1.22 = 3.28%. Answer is d.

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