Question 5 The spot dollar-pound rate is $1.80/l and the one year forward rate i

Question

Question 5 The spot dollar-pound rate is $1.80/l and the one year forward rate is $1.75/£1. You expect the spot dollar-pound rate will be $1.60/1 in one year's time. You have £l million to speculate with (i) Do you buy or sell £l million in the forward market? [1] ii) What is your profit in both dollars and pounds if you are correct and the spot dollar-pound rate is S1.60/El in one year's time? [2 (ii) What is you loss in both dollars and pounds if you are wrong and the spot sterling rate is S1.90/El in one years' time? [2] Question 6 What is a credit default swap (CDS)? Give a numerical example of how it works. 151

Explanation / Answer

5. i) Dollar is appreciating against pound in one year's time. Therefore, you should sell pound in forward market to realise greater value.

ii) If spot dollar-pound rate is $1.60/ £1 in one year's time, dollar profit realised in forward market:

(Forward rate - Future spot rate) x £1,000,000

=( $1.75 - $1.60) x  £1,000,000 = $150,000

Profit in pounds = $150,000/$1.60 =  £93,750

iii) If spot dollar-pound rate is $1.90/ £1 in one year's time, it means that dollar is depreciating against pound and pound is getting stronger. Dollar loss realised in forward market:

(Forward rate - Future spot rate) x  £1,000,000

=( $1.75 - $1.90) x  £1,000,000 = ($150,000)

Loss in pounds = $150,000/$1.60 = (£93,750)

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