Scenario: Jim Logan, the owner of an American based smallbusiness, Sports Exports, Inc., specializes in exporting footballsto Great Britain. In return, he receives payments in British poundsevery month which need to be converted into dollars. He has noticedthat the exchange rate between the dollar and the pound at the timeof exchange every month is significantly affecting his profits.Since he is a small business owner and not a foreign currencyexpert, he has hired your consulting firm to advise him withrespect to the following matters below.

A) Jim Logan recently heard on CNBC that inflation is expectedto rise substantially in the United Kingdom, while inflation in theUnited States will remain low. They also expect that the interestrates in both countries will rise by about the same amount. He asksyou to answer the following questions so that he may take theappropriate measures if CNBC is correct in their projections.

1. From an economic perspective, will the pound appreciate ordepreciate against the dollar and explain why?

2. Will Sports Exports, Inc. be favorably or unfavorablyaffected by the future changes and explain why?

3. How can Sports Exports, Inc. use currency futures contractsto hedge against exchange rate risk? Are there any limitations ofusing currency futures contracts that would prevent Sports Exports,Inc. from locking in a specific exchange rate at which it can sellall the pounds it expects to receive in each of the upcomingmonths?

4. How can Sports Exports, Inc. use currency options contractsto hedge against exchange rate risk? Are there any limitations ofusing currency futures contracts that would prevent Sports Exports,Inc. from locking in a specific exchange rate at which it can sellall the pounds it expects to receive in each of the upcomingmonths?

5. While Mr. Logan believes the CNBC report, he would also liketo know what to do if CBNC is incorrect specifically with respectto using futures or options to hedge the exchange rate risk in thisopposing scenario? Are there any disadvantages in thisscenario?

B) The check (denominated in pounds) for last month’s exportsjust arrived. Mr. Logan normally deposits the check with his localbank and requests that the bank convert the check to dollars at theprevailing spot rate (assuming that he did not use a forwardcontract to hedge this payment). Logan’s local bank providesforeign exchange services for many of its business customers whoneed to buy or sell widely traded currencies. Today, however, Logandecided to check the quotations of the spot rate at other banksbefore converting the payment into dollars.

1. Mr. Logan wants to know whether your firm thinks that this isa worthwhile thing for him to do so. Specifically, will he be ableto find a bank to provide him with a more favorable spot rate thanhis local bank? Explain?

2. Do you think that Mr. Logan’s bank is likely to provide morereasonable quotations for the spot rate of the British pound if itis the only bank in town that provides foreign exchange services?Explain?

3. Logan is also considering using a forward contract to hedgethe anticipated receivables in pounds next month. His local bankquoted him a spot rate of $1.35 and a 1-month forward rate of$1.3435. Before he decides to sell pounds 1 month forward, he wantsto be sure that the forward rate is reasonable, given theprevailing spot rate. A 1-month Treasury security in the U.S.currently offers a yield (not annualized) of 1%, while a 1-monthTreasury security in the U.K. offers a yield of 1.4%. Does yourfirm believe that the 1-month forward rate is reasonable given thespot rate of $1.35?

C) Now, Mr. Logan is questioning whether this process is worththe trouble. He suggests that if the international Fisher effect(IFE) holds, the pound’s value should change (on average) by anamount that reflects the differential between the interest rates ofthe two countries of concern. Because the forward premium reflectsthe same interest rate differential, the results from hedgingshould equal the results from not hedging on average.

1. Is Logan’s interpretation of the IFE theory correct? Why?

2. If you were in Logan’s position, would you spend time tryingto decide whether to hedge the receivables each month, or do youbelieve that the results would be the same (on average) whether youhedge or not?

D) Mr. Logan expects that British inflation will risesubstantially in the future. In previous years when the Britishinflation was high, the pound depreciated. The prevailing Britishinterest rate is slightly higher than the prevailing U.S. interestrate. The pound has risen slightly over each of the last severalmonths. Mr. Logan wants you to forecast the value of the pound foreach of the next 20 months. You explain to him that this willresult in an additional fee, but that your firm will explain howthe extra service would work?

1. Explain how you can use technical forecasting to forecast thefuture value of the pound. Based on the information provided, doyou think that a technical forecast will predict futureappreciation or depreciation in the pound?

2. Explain how you can use fundamental forecasting to forecastthe future value of the pound. Based on the information provided,do you think that a technical forecast will predict futureappreciation or depreciation in the pound?

3. Explain how you can use market-based forecasting to forecastthe future value of the pound. Based on the information provided,do you think that a technical forecast will predict futureappreciation or depreciation in the pound?

4. Does it appear that all of the forecasting techniques willlead to the same forecast of the pound’s future value? Whichtechnique would you prefer to use in this situation?