Question
Assignment Description
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 $500,000 to invest in the spot, forward, or options markets. Assume that the spot rate is $1.3435 to the euro and that the forward rate for 12 months is $1.3705 to the euro. However, this leader is sure that the exchange rate in 12 months will be $1.41 to the euro.
In a Word document, include the following:
- Explain how this leader in your firm can speculate on the belief that the euro will be $1.41 in 12 months.
- Calculate the amount of profit (ignoring exchange rate fees) that can be earned and the percentage return achieved.
- Recommend whether this speculative investment or another investment with similar or higher returns at lower risk should be selected. Explain your reasoning.
- Be sure to consider how the inflation rate would affect the return.
Answer
International Risk Management
The leader can speculate on the belief that the euro will be $1.41 in 12 months by analyzing a number of economic indicators. First, the leader may have observed that the economic health of the U.S. is deteriorating, a trend expected to last over the next 12 months or more. Various indicators such as slow growth, high debt burden and inflation rates may cause the dollar to lose its strength relative to the euro. The leader could have speculated reduced foreign trade due to either high local taxes or introduction of policies and regulations that are unfavorable to trade. Trade deficits in a country may lead to depreciation of the currency. If the government comes up with policies that are favorable to trade, one may speculate that the country’s currency will gain strength relative to other currencies.
The leader can generate different profits by investing the money in the spot, forward, or options market. The following showings the profits to be derived from each of the options.
First, the leader can buy the euros now and then invest the money in the spot after 12 months, meaning the exchange rate will be 1.41 by then. The amount derived from this option will be:
The rate of return is thus: %
The second option is to invest the $500,000 using the forward option. In using the forward option, the leader will have to agree on a fixed interest rate today, for a purchase or a transaction that will be made in future (Fabozzi, Mann, & Choudhry, 2002). As per the forward contract, the amount to be made will be calculated as follows:
The leader can also try the options market. In this strategy, the leader will buy an option that gives the right to purchase euros in 12 months from the specified date and at a specific rate. If all expectations are fulfilled, then the leader will make a gain resulting from the difference between the option price and the spot price. The profit derived will thus be $24,749 excluding the costs of the forward contract.
The leader should proceed with the investment. From the analysis, it may be difficult for the leader to find other profitable alternatives. The options strategy will be the best for the leader or organization to invest in. An option will enable the organization acquire the right to buy or sell an underlying asset. An option is valid for a specific period of time. Inflation rates can significantly impact the returns. Inflation refers to the general increase in prices of basic commodities that occurs over a long period such as one year.
Inflation erodes the value of an investment. As such, inflation would reduce the total value of the investment made by the leader. The actual rate of inflation represents the loss of value that occurs to an investment. As such, inflation rate may be termed as the loss-of-value rate for the particular investment. Investors may use the inflation rate to gauge how much returns an investment should give in order to the investors to maintain their living standards.
References
Fabozzi, F. J., Mann, S. V., & Choudhry, M. (2002). The global money markets. Hoboken, N.J: J. Wiley.
