David,
Please see the Q&A given below. I have a basic doubt - If we are saying that F1 and S (at time 1) are different, then doesn't that imply arbitrage opportunity? So, if F1 = S (at time 1, then the payoff should be zero. Ditto for the F2 contract. Am I missing something?
Thanks,
CandidFRM
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On July 1, 2006, a US company enters into a forward contract to buy 10 million GBP on January 1, 2007. On September 1, 2006, it enters into a forward contract to sell 10 million GBP on January 1, 2007. Describe the profit or loss the company will make in dollars as a function of the forward exchange rates on July 1, 2006 and September 1, 2006.
Answers:
Suppose F1 and F2 are the forward exchange rates for the contracts entered into July 1, 2006 and September 1, 2006, and S is the spot rate on January 1, 2007. (All exchange rates are measured as dollars per pound). The payoff from the first contract is 10(S – F1) million dollars and the payoff from the second contract is 10(F2 – S) million dollars. The total payoff is therefore 10(S – F1) + 10(F2 – S) = 10(F2 – F1) million dollars.
Please see the Q&A given below. I have a basic doubt - If we are saying that F1 and S (at time 1) are different, then doesn't that imply arbitrage opportunity? So, if F1 = S (at time 1, then the payoff should be zero. Ditto for the F2 contract. Am I missing something?
Thanks,
CandidFRM
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On July 1, 2006, a US company enters into a forward contract to buy 10 million GBP on January 1, 2007. On September 1, 2006, it enters into a forward contract to sell 10 million GBP on January 1, 2007. Describe the profit or loss the company will make in dollars as a function of the forward exchange rates on July 1, 2006 and September 1, 2006.
Answers:
Suppose F1 and F2 are the forward exchange rates for the contracts entered into July 1, 2006 and September 1, 2006, and S is the spot rate on January 1, 2007. (All exchange rates are measured as dollars per pound). The payoff from the first contract is 10(S – F1) million dollars and the payoff from the second contract is 10(F2 – S) million dollars. The total payoff is therefore 10(S – F1) + 10(F2 – S) = 10(F2 – F1) million dollars.