Conceptual Exercise

While you were visiting London, you purchased a Land Rover for 35,000, payable in 3 months. You have enough cash at your bank in New York City, which pays 4% p.a which gets compounded monthly, to pay for the car. Currently, the spot exchange rate GBP/USD is 1.5125/28 and the 3 month forward rate is 1.5045/53. The interest rate in London is 6% p.a. There are 2 alternatives for payment:a. Invest the funds in the bank in USD and book 3 months forward contract for GBP35,000 for your payment. b. You may invest equivalent GBP today which will mature as GBP35,000 after 3 months.

You are expected to work out the equivalent USD in both the cases and then evaluate each payment method. Which method would you prefer? Why? a. Equivalent amount of USD to pay GBP 35,000 = USD 52,948 Amount for Bank Fund 52,948/(1+0.04(90/360) = USD 52,423.76 So, USD invested today including Hedging Cost of 1.98% = 53,461.75 b. Amount of GBP investment 35,000/(1+0.06(90/360) = GBP 34,482.76 So, buy USD to invest in GBP = USD 52,165.52 Hence, investing in GBP is better option.