While you were visiting London, you purchased a Jaguar for E35,000, payable in t

Question

While you were visiting London, you purchased a Jaguar for E35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35 percent interest per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is S1.45/E and the three-month forward exchange rate is $1.40/E. In London, the money market interest rate is 2.0% for a three-month investment. There are two altemative ways of paying for your Jaguar. 1. a. Keep the funds at your bank in the United States and buy £35,000 forwarod b. Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to 535,000. method. Which method would you prefer? Why? (Hint: US interest rate is 0.35% per month, compounding monthly, not annual rate, the 2% in London is a three-month rate, not annual rate or monthly rate)

Explanation / Answer

Purchase Price £   35,000 Pound USD=(1+.35%)^3-1 1.05368% 3 month compounding interest Spot Rate USD 1.45= 1 Pound Forward rate USD1.40=1Pound a. Keep the fund at bank in US Total Money Required=35000*1.40/(1+1.05368%)                     48,489 Interest for three Month @1.05368%                           511 Total Amount in USD                     49,000 Forward rate after three month @1.40 1.4 Pound Amount after three months £                35,000 b. Buy Pound today @1.45USD=1Pound=35000/102%*1.45 $                49,755 Total Pound Purchased =49755/1.45 £                34,314 Interest @2% £                686.27 Total Amount after three month £                35,000 Conclusion: Option (a) is better as USD required 48,489 to pay pound 35,000 after three month whereas 49755 which USd1,266 is higher to pay

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