3. You are concerned about your transaction exposure on a recent purchase from a

Question

3. You are concerned about your transaction exposure on a recent purchase from an exporter in Great Britain. The invoice, just received, is for 275,000 pounds sterling payable in 90 days which will be about mid-June. The current exchange rate is $1.35 per pound sterling, and you fear that the dollar will depreciate against the pound due to the relatively low interest rates currently prevailing in the United States. The following forward rate is $1.38. a. What is the cost of the invoice in dollars at the current spot rate? b. If a forward contract is purchased, what will be the cost of the invoice in dollars at the forward rate? c. Describe the advantages and disadvantages of hedging the transaction with a forward contract

Explanation / Answer

Solution: a. The cost of the invoice in dollars at current spot rate = $371,250 Working Notes: The cost of the invoice in dollars at current spot rate = Invoice value x Spot rate = 275,000 pounds x $1.35 per pound = $371,250 b. The cost of the invoice in dollars at forward rate = $379,500 Working Notes: The cost of the invoice in dollars at forward rate = Invoice value x Forward rate = 275,000 pounds x $1.38 per pound = $379,500 c. Advantages of using forward contract to hedging the transaction I. Under forward contract we will get exact amount of invoice hedged II. Under forward contract we will get required pounds sterling at fixed rate (forward rate) at specific date. III. There is no any charges or premium or fees or commissions at initial stage only payment is made at settlement date. Disadvantages of using forward contract to hedging the transaction I. Under Forward contract the contractual commitment should be completed on due date (Specific date under contract) II. Under forward contract the favorable movements in exchange rates are not pass on the customer. III. Forward contract are not easily available in all markets & in all currency all time. Please feel free to ask if anything about above solution in comment section of the question.

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