Anna Goldsworthy is the chief financial officer of a manufacturing firm headquartered in the United Kingdom. She is responsible for overseeing exposure to price risk in both the commodity and currency markets. Goldsworthy is settling her end-of quarter transactions and creating reports. Her intern, Scott Underwood, assists her in this process.

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 As Spot Exchange Rates

Spot Exchange Rates

Currency Pair (Price/Base) Bid Offer Midpoint

JPY/GBP 187.39 187.43 187.41

MXN/USD 17.147 17.330 17.239

GBP/EUR 0.7342 0.7344 0.7343

USD/EUR 1.1572 1.1576 1.1574

USD/GBP 1.5762 1.5766 1.576

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 1.5760/1.5768.

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 0.0366/0.0372. 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 ninemonth forward contract at an all-in price of GBP/EUR 0.7400. 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.

The below are the questions to be answered with a brief justification:

Q1) Using the quotes in Exhibit 1, the amount received by Goldsworthy from converting JPY 225,000,000 will be

1. GBP 1,200,448

2. GBP 1,200,576

3. GBP 1,200,704

Q2) Using Exhibit 1, which of the following would be the best reason for the revised USD/GBP dealer quote of 1.5760/1.5768?

1. A request for a much larger transaction
2. A drop in volatility in the USD/GBP market
3. A request to trade when both NEW and London trading centers are opened

Q3) Using the quotes from Dealer A and B, the triangular arbitrage profit on a transaction of MXN 27,000,000 would be closest to:

1. GBP 0
2. GBP 5,400
3. GBP 10,800

Q4) Based on Exhibits 1, 2, and 3, the mark-to-market gain for Goldsworthys forward position is closest to:

1. GBP 20,470
2. GBP 20,500
3. GBP 21,968

Q5) Based on Exhibit 2, Underwood should conclude that three-month EUR Libor is:

1. Below three-month GBP Libor
2. Equal to three-month GBP Libor
3. Above three-month GBP Libor

Q6) Based on the exchange rate midpoint in Exhibit 1 and the rates in Exhibit 3, the 90-day forward premium (discount) for the USD/GBP would be closest to:

1. -0.0040
2. -0.0010
3. +0.0010

Q7) Using Exhibits 1, 2, and 3, which international parity condition would Goldsworthy most likely use to calculate the EUR Libor?

1. Real interest rate parity
2. Covered interest rate parity
3. Uncovered interest rate parity

Q8) The international parity condition Goldsworthy will use to provide the estimate of the future JPY/GBP spot rate is most likely:

1. Covered interest rate parity
2. Uncovered interest rate parity
3. Relative purchasing power parity