Financial Risk Manager Part 1
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A bank located in Italy has entered into a 6-month forward contract with an importer, agreeing to exchange GBP 80 million for EUR at a fixed rate of 1.13 EUR per GBP. Over the course of the 6 months, the exchange rate has shifted to 1.12 EUR per GBP. Determine the financial gain or loss that the bank experiences as a result of this forward contract.
A bank located in Italy has entered into a 6-month forward contract with an importer, agreeing to exchange GBP 80 million for EUR at a fixed rate of 1.13 EUR per GBP. Over the course of the 6 months, the exchange rate has shifted to 1.12 EUR per GBP. Determine the financial gain or loss that the bank experiences as a result of this forward contract.
Explanation:
D is correct. The value of the contract for the bank at expiration: GBP80,000,0001.13EUR/GBP=EUR 90,400,000. The cost to close out the contract for the bank at expiration: GBP80.000,0001.12EUR/GBP=EUR89,600,000. Therefore, the final payoff in EUR to the bank can be calculated as: 90,400,000-89,600,000=EUR800,000 or 80,000,000* (1.13-1.12)=EUR 800,000. A is incorrect. The EUR has appreciated against the GBP and in 6 months the forward contract worked in favor of the bank's short position, so the net payoff is positive for the bank, and not negative. B is incorrect. As explained in D and A, the net payoff is positive for the bank, and not negative. Also, the contract has 6-month terms and there no need to multiply the net payoff by 0.5 ((i.e., GBP 80,000,000*(1.13 -1.12)EUR/GBP)*0.5 =EUR 400,000). C is incorrect, as explained in D and B above.