Suppose that the following prices are given as true transaction prices: Spot Yen

Question

Suppose that the following prices are given as true transaction prices:

Spot Yen $0.0153

3-month Forward Yen $0.0155

3-month Yen interest rate 2.0654%

3-month Dollar interest rate 6.0120%

Suppose that you are the manager of a firm that has a payment of 2 million yen due in 90 days and you want to lock in a price today.

Consider the two paths below:

Path 1: investing dollars for 90 days and then selling dollars for yens at the forward rate

Path 2: selling the dollars for yens at the spot rate and investing yens for 90 days Which is the best way for you to transact or are the paths equivalent?

Explanation / Answer

Path 1:

Require 2 million Yen after 90 days.

Forward rate = 1 Yen = $0.0155.

Thus, dollars require for convervent to yen in 90 days = Yen 2,000,000 * 0.0155 = $31,000.

Interest rate = 6.0120%.

Interest for 90 days = 6.0120 * 90/360 = 1.503

Amount to be invested now = 31,000*98.497 / 100 = $30,534.

Path 2:

Require 2 million Yens in 90days.

Yen Interest rate = 2.0654%

Yen Interest rate for 90 days = 2.0654 *90/360 = 0.51635%.

Amount to be invested now in yens = 2000000 * 99.48365/100 = Yen 1,989,673.

Amount of doolars to be converted to yens now = 1989673*0.0153 = $30,442.

Therefore, Path 2 is better as the amount to be invested in dollars now is lesser.

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