Whereas you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have sufficient cash at your bank in New York City that pays 0.35% interest per month, compounding monthly, to pay for the car. At present, the spot exchange rate is as $1.45/£ and the three-month forward exchange rate is as $1.40/£. In London, the money market interest rate is 2.0% for three-month investment. There are two choice of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. & buy £35,000 forward.
(b) Buy certain pound amount spot nowadays and invest the amount in the U.K. for three months so that the maturity value becomes equivalent to £35,000.
Assess each payment method. Which method should be preferred? Why?
The problem is summarized as follows:
A/P = £35,000 payable in three months
iNY = 0.35%/month, compounding monthly
iLD = 2.0% for three months
S = $1.45/£; F = $1.40/£.
Option a:
While you buy £35,000 forward, you will require $49,000 in three months to fulfil the forward contract. The current value of $49,000 is calculated as follows:
$49,000/(1.0035)3 = $48,489.
Therefore, the cost of Jaguar as of nowadays is $48,489.
Option b:
The current value of £35,000 is £34,314 = £35,000/(1.02). To purchase £34,314 today, it will cost $49,755 = 34,314x1.45. Therefore the cost of Jaguar as of today is $49,755.
You have to definitely choose to use “option a”, and save $1,266, that is the difference between $49,755 & $48489.