1. If the spot rate for British pounds is 0.57 pounds equals 1 US $, and the annual interest rate on fixed rate one-year deposits of pounds is 3.5% and for US$ is 2.5%, what is the ten-month forward rate for one dollar in terms of pounds? Assuming the same interest rates, what is the 18-month forward rate for one pound in dollars? Is this an indirect or a direct rate? If the forward rate is an accurate predictor of exchange rates, in this case will the pound get stronger or weaker against the dollar? What does this indicate about the market’s inflation expectations in the UK compared to the US?

Spot rate for $1 = 0.57 pounds

Fixed interest rate for pounds = 3.5%

Interest rate for US dollars = 2.5%

Ten month forward rate is calculated as

Forward exchange rate = Spot price * [(1+foreign interest rate) / (1 + Base interest rate)]^n

= 0.57 * [ (1 + 0.035) / (1+0.025)]^(10/12)

= 0.57 * [ 1.0097] ^0.833

= 0.57 * 1.0080

= 0.57456

Spot rate for $1 = 0.57 pounds

1 Pound = $1.754

Forward exchange rate for 18 months = $1.754 * [ (1 + 0.025) / (1+0.035)]^(18/12)

= $1.754 * [ 0.99] ^1.5

= $1.754 * 0.985

1 Pound = $1.7277

This is a direct rate because in quoting a foreign exchange rate it is quoted as the domestic currency per unit of the foreign currency.

If the forward rate is an exact predictor of the exchange rate, then the pound will becomes stronger against dollars as for one pound it can get $1.754 dollars. Therefore, the pound appreciates against dollar.

We know that there is an inverse relation between the currency exchange rate and the inflation rate.

Here the pound became stronger and appreciates in value against dollar. For one pound we can buy 1.754 dollars. Therefore, the purchasing power parity increases in UK and the prices of goods increases due to increased Purchasing power parity. Therefore, the inflation rate increases due to the increased prices.

Hence the inflation rate increases in UK and decreases in US

2. On January 2nd, 2011, BMW expects to ship 19,000 Mini-Cooper cars from its affiliated plant in the UK to the US, which it will sell through US dealers on 300-day terms at $26,500 each. So BMW will receive payment from its dealers on October 28th, 2011.

Assuming that BMW needs to cover its expenses in the UK and thus wants to hedge its pound exposure using a forward contract with a UK bank in the US, what is the minimum amount of pounds they should receive on October 28th, 2011 given the ten month forward rate for one US dollar in terms of pounds?

What are two other ways BMW might hedge their pound/dollar exposure?

Ten month forward rate is 1 Pound = $1.754

Hedge using forward contract

Amount receivable by BMW ($26,500*19,000 mini-cooper cars) = $ 503,500,000

Ten month forward rate is 1 Pound = $1.754

Amount received on October 28, 2011 in pounds = 287,058,153

Other ways of hedging pound/dollar exposure:

1) One of hedging is to invoice the sale value in UK pounds so that a fixed amount in UK pounds will be received whether US dollars falls or increase as compared to UK pound

2) BMW can create a hedge by fixing the value of receivables now in domestic currency. This way is called money market hedge. BMW can borrow money in us dollars, then convert this in UK sterling and invest this amount, after 10 months time the amount to be paid to bank will be equal to the amount which will be received in US dollars.

3) BMW can also hedge their currency exposure by entering in currency futures.

4) Currency options is also a method.

5) Currency swaps arrangements can also be entered for hedging the currency risk.

3. In his book Manias, Panics and Crashes (see the Introduction and Chapters posted on the class website) Charles Kindleberger explains the three stages of how a financial crisis develops and evolves over time. Please briefly explain these stages and how the 1997 Asian Financial Crisis as presented in the Hill text and the class case presentation follows this economic pattern or paradigm.