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? Describe the advantages and disadvantages of hedging the transaction with a forward contract. c.

Explanation / Answer

a) here invoice price is 275000 pounds sterling

current exchange rate is $1.35 per pound sterling

that is $1.35= 1 pound sterling

so, 275000 pound sterling =1.35 *275000=$371250

cost of invoice in dollars=$371250

b) forward rate is $1.38 per pound sterling

the cost of invoice in dollars will be 1.38*275000=$379500

c) Advantage

1. A forward contract fixes the future rate and hence helps in eliminating downward risk.

2.A forward contract is customizable and can be prepared to suit the needs of both the parties involved.

Disadvantage

1) A forward contract has high amount of default risk.

2) Since a forward contract is customizable to suit both parties, this fact also make them highly iiliquid

as one might have to look for another party who is looking for simiar terms in a contract.

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