Problem

You manufacture wine goblets.  In mid June you receive an order for 10,000 goblets from Ja...

You manufacture wine goblets.  In mid June you receive an order for 10,000 goblets from Japan.  Payment of ¥400,000 is due in mid December.  You expect the yen to rise from its present rate of $1=¥130 to $1=¥100 by December.  You can borrow yen at 6% per annum.  What should you do?

Step-by-Step Solution

Solution 1

The simplest solution would be to just wait until December, take the ¥400,000 and convert it at the spot rate at that time, which you assume will be $1=¥100.  In this case you would have $4,000 in mid-December.  If the current 180-day forward rate is lower than 100¥/$, then a forward contract might be preferable since it both locks in the rate at a better level and reduces risk.  If the rate is above ¥100/$, then whether you choose to lock in the forward rate or wait and see what the spot does will depend upon your risk aversion.  There is a third possibility also.  You could borrow money from a bank that you will pay back with the ¥400,000 you will receive (400,000/1.03 = ¥388,350 borrowed), convert this today to US$ (388,350/130 = $2,987), and then invest these dollars in a US account.  For this to be preferable to the simplest solution, you would have to be able to make a lot of interest (4,000 - 2,987 = $1,013), which would turn out to be an annual rate of 51% ((1,013/4000) * 2).  If, however, you could lock in these interest rates, then this method would also reduce any exchange rate risk.  What you should do depends upon the interest rates available, the forward rates available, how large a risk you are willing to take, and how certain you feel that the spot rate in December will be ¥100 = $1.

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Solutions For Problems in Chapter 9