Forward contracts

by | Mar 18, 2023 | finance

 

Assume that the 1-year forward exchange rate is currently traded at $1.25/E. The spot pound to US dollar exchange rate is $1.21/E.
An investor decides to undertake the following trade today:
o Borrow $1000 at the prevailing interest rate (0.425%)
o Use the borrowed funds to buy GBP in the spot market
o Invest the funds nominated in GBP at the prevailing interest rate (1.2%)
o Enter the forward contract to sell the expected proceeds for dollars one year from now.
Calculate the returns (profits) from this trade to the investor one year from now. (Calculation 6 marks) Comment on your results. ( appropriateness of comment, 7 marks)

Sample Solution

The returns (profits) from this trade to the investor one year from now can be calculated as follows:

1. Borrow $1000 x 0.00425 = 4.25 – This represents the interest paid on the borrowed funds.

2. Buy GBP with borrowed funds at spot rate of 1.21/E = 810 GBP

3. Invest 810 GBP in UK account and earn 1.2% interest over a year = 972 GBP

4. Sold forward at expected rate of 1.25/E = 1215 USD

5. Net return for investor after paying back loan amount of 1000USD plus interest is equal to 1215-1000-4,25= 210,75 USD or 17 % return on investment.

Sample Solution

The returns (profits) from this trade to the investor one year from now can be calculated as follows:

1. Borrow $1000 x 0.00425 = 4.25 – This represents the interest paid on the borrowed funds.

2. Buy GBP with borrowed funds at spot rate of 1.21/E = 810 GBP

3. Invest 810 GBP in UK account and earn 1.2% interest over a year = 972 GBP

4. Sold forward at expected rate of 1.25/E = 1215 USD

5. Net return for investor after paying back loan amount of 1000USD plus interest is equal to 1215-1000-4,25= 210,75 USD or 17 % return on investment.

The results are quite impressive given that most investments tend to offer less than 10% annual returns and in this case, even with taking into account exchange rate risk, the investor has been able to get an additional 7%. Moreover due to the favourable forward exchange rate of 1,25/E compared with current spot rate being 1,21 /E there is potential realize additional gains if currency appreciates during period holding which could potentially increase overall profits even further.< br >< br >In conclusion it seems like this investment strategy was well thought out and viable option for investors who want exposure foreign markets but also want hedge their risk against fluctuations exchange rates by entering forward contracts future dates when they feel market conditions more favourable their desired outcomes

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