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Foreign Exchange Markets: Paperwork for Exports

1) A leader in your firm has been studying the foreign exchange market for a number of years and believes that she can predict several of the foreign currency exchange rates relative to the U.S. dollar. The firm has $300,000 to invest in the spot, forward, or options markets. The spot rate is $1.2622 to the euro, and in 12 months, the forward rate is $1.2905 to the euro. However, this leader is sure that the exchange rate in 12 months will be $1.33 to the euro. Explain how she can speculate on the belief that the euro will be $1.33 in 12 months. Calculate the amount of profit (ignoring exchange rate fees) that will be earned and the percentage return achieved.

2) All of the terms and paperwork necessary to export products and services can be very confusing. Please explain the advantages and disadvantages associated with using a letter of credit, a bill of exchange (or draft), and the Export-Import Bank of the United States.

Solution Preview

A leader in your firm has been studying the foreign exchange market for a number of years and believes that she can predict several of the foreign currency exchange rates relative to the U.S. dollar. The firm has $300,000 to invest in the spot, forward, or options markets. The spot rate is $1.2622 to the euro, and in 12 months, the forward rate is $1.2905 to the euro. However, this leader is sure that the exchange rate in 12 months will be $1.33 to the euro. Explain how she can speculate on the belief that the euro will be $1.33 in 12 months. Calculate the amount of profit (ignoring exchange rate fees) that will be earned and the percentage return achieved.

Spot rate = $1.2622 / Euro
12-month forward= $ 1.2905 / Euro (in the forward market)
Expected 12 month forward rate = $ 1.33 / Euro

If the expected 12 month forward rate is going to be $ 1.33 / Euro, then the forward Euro is undervalued when compared with the spot Euro, as 1 Euro should buy $1.33 dollars after 12 months whereas, it is actually buying only $ 1.2905 in the forward market. (This is the same as saying that the Forward dollar is overvalued when compared with the spot dollar).

To make profit, sell dear and buy cheap. That is, sell Euros for dollars in the spot market and buy Euros from dollars in the forward market.
The company already has dollars; therefore, there is no need to convert Euros to dollars in the Spot market.

Buy Euros forward.
($ 30,000 will buy 30,000/ 1.2905 = 23,246.80 Euros in the ...

Solution Summary

The solution calculates the amount of profit earned and the percentage return achieved for an investment in the foreign exchange markets as well as discusses advantages and disadvantages associated with using a letter of credit, a bill of exchange and the Export-Import Bank of the United States. 984 words.

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