A merchant in the UK has agreed to sell goods to an importer in the USA at an invoice price of $130,000. Of this amount, $40,000 will be payable on shipment, $60,000 one month after shipment and $30,000 three months after shipment.

The quoted foreign exchange rates ($ per ) at the date of shipment are as follows:

Spot rate (on shipment) 1.690 -1.692

Forward rate-(one month after) 1.687 -1.690

Forward rate-(three months after) 1.680 -1.684

The merchant decides to enter forward exchange contracts through his bank to hedge these transactions for fear that the future spot rates may change to his disadvantage. Required:

(a) i. State what are the presumed advantages of using forward exchange contracts.

ii. Calculate the sterling amount that the merchant would receive on these contracts.

5 iii. Comment on the wisdom of the merchant decision to hedge by comparing his total receipts in pound sterling, assuming the spot rate ($ per ) at the dates of receipt of first payment upon shipment remains the same but rates at the second instalment ($60,000) and third instalment ($30,000), were as follows:

Spot rate (one month after shipment) 1.694 -1.696

Spot rate (three months after shipment) 1.700 -1.704

(b) Describe how foreign exchange transactions using futures would differ from those using forward exchange contracts.

Hint: the bank always makes a profit on forex, by taking more of one currency in the exchange transaction and giving less of the other currency to the customer