The firm hedges input costs using forward contracts that are priced in US dollars (USD) and Mexican pesos (MXN). Processed goods are packaged for sale under licensing agreements with firms in foreign markets. Goldsworthy is expecting to receive a customer payment of JPY 225,000,000 (Japanese yen) that she wants to convert to pounds sterling (GBP). Underwood gathers the exchange rates from Dealer A in Exhibit 1.
Exhibit 1
Dealer A’s Spot Exchange Rates
Spot Exchange Rates | |||
Currency Pair (Price/Base) | Bid | Offer | Midpoint |
JPY/GBP | 129.65 | 129.69 | 129.67 |
MXN/USD | 20.140 | 20.160 | 20.150 |
GBP/EUR | 0.9467 | 0.9471 | 0.9469 |
USD/EUR | 1.1648 | 1.1652 | 1.1650 |
USD/GBP | 1.2301 | 1.2305 | 1.2303 |
The firm must also buy USD to pay a major supplier. Goldsworthy calls Dealer A with specific details of the transaction and asks to verify the USD/GBP quote. Dealer A calls her back later with a revised USD/GBP bid–offer quote of 1.2299/1.2307.
Goldsworthy must purchase MXN 27,000,000 to pay an invoice at the end of the quarter. In addition to the quotes from Dealer A, Underwood contacts Dealer B, who provides a bid–offer price of GBP/MXN 0.0403/0.0406. To check whether the dealer quotes are reflective of an efficient market, Underwood examines whether the prices allow for an arbitrage profit.
In three months, the firm will receive EUR 5,000,000 (euros) from another customer. Six months ago, the firm sold EUR 5,000,000 against the GBP using a nine-month forward contract at an all-in price of GBP/EUR 0.9526. To mark the position to market, Underwood collects the GBP/EUR forward rates in Exhibit 2.
Exhibit 2
GBP/EUR Forward Rates
Maturity | Forward Points |
One month | 4.40/4.55 |
Three months | 14.0/15.0 |
Six months | 29.0/30.0 |
Goldsworthy also asks for the current 90-day Libors for the major currencies. Selected three-month Libors (annualized) are shown in Exhibit 3. Goldsworthy studies Exhibit 3 and says, “We have the spot rate and the 90-day forward rate for GBP/EUR. As long as we have the GBP 90-day Libor, we will be able to calculate the implied EUR 90-day Libor.”
Exhibit 3
90-Day Libor
Currency | Annualized Rate |
GBP | 0.5800% |
JPY | 0.0893% |
USD | 0.3300% |
After reading a draft report, Underwood notes, “We do not hedge the incoming Japanese yen cash flow. Your report asks for a forecast of the JPY/GBP exchange rate in 90 days. We know the JPY/GBP spot exchange rate.” He asks, “Does the information we have collected tell us what the JPY/GBP exchange rate will be in 90 days?”
Goldsworthy replies, “The JPY/GBP exchange rate in 90 days would be a valuable piece of information to know. An international parity condition can be used to provide an estimate of the future spot rate.”
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