Discussion: Provide A Comprehensive Explanation Of Foreign E

Duscusison 1provide A Comprehensive Explanation Of Foreign Exchange Ma

Provide a comprehensive explanation of foreign exchange markets. Be sure to include examples of how forward markets and spot markets operate discussion 2 Read the scenario presented in Chapter 6 Problem #2 (at the end of the chapter): While you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35 percent interest per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and the three-month forward exchange rate is $1.40/£. In London, the money market interest rate is 2.0 percent for a three-month investment. There are two alternative ways of paying for your Jaguar. a. Keep the funds at your bank in the United States and buy £35,000 forward. b. Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to £35,000. Analyze the alternatives presented and make a recommendation on purchasing the Jaguar. Be sure to provide support for your recommendation – why do you prefer the stated alternative? What are the advantages of the alternative that you have selected?

Paper For Above instruction

Foreign exchange markets facilitate the trading of national currencies, which are essential for international trade and investment. These markets operate through various mechanisms, primarily spot and forward markets, enabling participants to manage exchange rate risk and facilitate currency transactions. Understanding these markets involves examining their functions, how they operate with practical examples, and their relevance in international financial activities.

The spot market is the most straightforward segment of the foreign exchange market, where currencies are bought and sold for immediate delivery, typically within two business days. It involves the purchase or sale of a foreign currency at the current exchange rate, known as the spot rate. For example, if an American company needs to pay a UK supplier, it might purchase British pounds at the current spot rate of $1.45/£ to settle the transaction immediately. The transaction is settled quickly, and the currency exchange occurs at the prevailing spot rate. Spot markets are essential for short-term currency needs and provide liquidity and immediate currency exchange for global participants.

In contrast, the forward market involves agreements to buy or sell currencies at a predetermined future date and at a specific exchange rate, known as the forward rate. Forward contracts are used primarily for hedging exchange rate risk, especially when firms expect future currency requirements. For instance, a US company expecting to pay £35,000 in three months might enter into a forward contract locking in the rate of $1.40/£. This ensures the company knows the exact cost in USD, regardless of fluctuations in the exchange rate. Forward markets help stabilize costs and revenues by allowing firms to hedge against adverse currency movements.

Operationally, forward and spot markets serve different purposes but are interconnected. While spot markets are used for immediate needs, forward contracts tailor future exchanges to match anticipated obligations, offering protection against unpredictable currency fluctuation. They are traded over-the-counter (OTC), providing flexibility for customizing terms, such as delivery date and amount. The liquidity and transparency of these markets impact the exchange rate dynamics crucial for international traders and investors.

Applying the scenario involving the Jaguar purchase, two methods are evaluated for paying in pounds (£): using a forward contract or executing a synthetic approach via the spot market and UK investment. The first alternative involves locking in the current forward rate of $1.40/£ by buying the forward now, thereby fixing the cost of the £35,000 payable in three months. The current spot rate is $1.45/£, but since the forward rate is lower, it suggests a market expectation of a depreciation of the dollar relative to the pound or a premium for the forward contract.

The second approach entails purchasing a specific amount of pounds at the current spot rate, then investing those pounds in the UK market at 2.0 percent for three months to accumulate enough to purchase the Jaguar at £35,000. To determine this, the required present amount in pounds must grow by 2.0 percent over three months to reach £35,000. The initial amount in pounds needed is calculated as £35,000 / (1 + 0.02) = approximately £34,313.73. The amount in USD to buy this at the current spot rate ($1.45/£) equals £34,313.73 * $1.45 = approximately $49,793.49. This approach leverages the interest rate differential between the US and UK markets and the current spot rate to potentially minimize costs.

Comparing these alternatives, the forward contract provides certainty in costs and is simpler to execute, eliminating the risks associated with currency fluctuations during the three-month period. The forward rate of $1.40/£ is lower than the current spot, which could lead to cost savings if the future spot rate remains above this level. Conversely, the spot investment strategy depends on the accuracy of future exchange rates and the UK interest rate, which might introduce uncertainty but could be advantageous if the USD depreciates more than expected relative to the pound.

Given the context where the forward rate is at $1.40/£ and the spot rate is higher at $1.45/£, purchasing the forward contract seems more advantageous. It locks in a lower exchange rate, ensuring the total USD expenditure does not exceed $49,000 (35,000 * 1.40), which is less than the USD cost of directly purchasing the pounds at the spot rate and investing. Additionally, the fixed rate eliminates exchange rate risk, providing financial certainty and simplifying budgeting for the purchase.

In conclusion, the recommendation leans toward entering into the forward contract to purchase £35,000 at the agreed forward rate of $1.40/£. This approach offers cost savings, hedges against currency fluctuations, and provides certainty for the expense, aligning with prudent financial management practices in international transactions. The ability to lock in costs effectively minimizes risks associated with currency volatility, which is critical for making international purchases like the Jaguar in this scenario.

References

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