While you were visiting London, you purchased a Jaguar for £60,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35% 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 5.0% for a three-month investment (periodic rate). There are two alternative ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £60,000 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 £60,000.
Evaluate each payment method. Which method would you prefer? Why?
1. Keep your money in the US and use a forward contract to convert into Pounds.
Cost of this strategy is $83124
2. Convert your money into pounds and invest at the british pound rate of 5% for 2 months.
Cost of this strategy is $82857
3. Keep your money in the US and use a forward contract to convert into pounds.
Cost of this strategy is $81145
4. Convert into BP today and invest at the BP rate of 5% quarterly. Cost is 80,064