Three month forward rate
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A U.S. corporation, Forever Young, Inc., intends to import $1,000,000 worth of cosmetics from Switzerland and will make payment in SF three months from now.The foreign exchange spot rate of Swiss franc to the U.S. dollar is SF6/$. Annual interest rates for U.S. dollar and Swiss franc are 5 percent and 8 percent, respectively.
a. What is the three-month forward rate for French franc if interest-rate parity holds?
b. How can Forever Young, Inc., use currency trading to hedge against the foreign exchange risk associated with the purchase?
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This provide the steps to compute the three month forward rate
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Three month forward rate=
f 3month = (1+rsf/1+ru)*e
rsf= rate of interest of sf
rusa= rate of interest of usa
e = Exchange rate
This rate will be divided by 4 to get three monthly returns :
(1+.08/4)/(1+.05/4)*6
=(1.02/1.0125)*6
=$6.044
b. How can Forever Young, Inc., use currency trading to hedge against the foreign exchange risk associated with the purchase?
Forever faces the currency risk. It should manage the risk in following manner:
Translation exposure
is simply the difference between exposed assets and exposed liabilities. The controversies among accountants' center on which assets and liabilities are exposed and on when accounting-derived foreign exchange gains and losses should be recognized (reported on the income statement). A crucial point to realize in putting these controversies in perspective is that such gains or losses are of an accounting nature-that is, no cash flows are necessarily involved.
Firms have three available methods for managing their translation exposure: (1) adjusting fund flows, (2) entering into forward contracts, and (3) exposure netting.
Adjusting the fund flows
Essentially, the strategy involves increasing hard currency (likely to appreciate) assets and decreasing soft currency (likely to depreciate) assets, while simultaneously decreasing hard currency liabilities ...
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