Page 129 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes (b) If the spot rate expected in 90 days is $1.5050, what is the expected cost of payment?
(c) Discuss the factors that will influence the hedging decision.
Solution:
An importer has a payment of £10 million due in 90 days.

(a) The hedged cost of making the payment is $15201000 (10,000,000 × 1.5201).
(b) The expected cost of payment is $15050000 (10,000.000 × 1.5050).
(c) The importer must consider the basis for its expected future spot rate and why that value
diverges from the forward rate, his willingness to bear risk, and whether he has any
offsetting pound assets.
Problem 2:

Assume that a foreign exchange trader assesses the French franc exchange rate three months
hence as follows:
$0.21 with probability 0.25

$0.23 with probability 0.50
$0.25 with probability 0.25
The 90-day forward rate is $0.24.
(a) Calculate the volume in which the trader buy or sell French francs forward against the
dollar if he is concerned only with expected values?
(b) In a real life scenario, what is likely to limit the trader’s speculative activities?
(c) Assume the trader revises his probability assessment as given:

$0.19 with probability 0.33
$0.23 with probability 0.33
$0.27 with probability 0.33
If the forward rate remains at $0.24, will the revised estimates affect the trader’s decision?
Explain.
Solution:
(a) The expected future spot exchange rate is $. 23 ($.21 × .25 + $.23 × .50 + $.25 × .25). Because
this is less than the forward rate of $.24, the trader will buy dollar forward against the
French francs. She should buy an infinite amount of dollars. This absurd result is due to the
assumption of a linear utility function.
(b) Regardless of his utility function, he will be restrained by bank policies designed to guard
against excessive currency speculation.
(c) The expected future spot rate remains at $.23 approximately. However, the variance of the
expected spot rate is now greater than it was before. If the trader is concerned solely with
expected values, this will not affect his speculative activities. But if he is concerned with
risk in addition to expected return, the greater variance and consequent greater risk should
lead him to reduce his speculative activities.

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