Suppose interest rate parity held. What would the one-year forward rate be?

Suppose interest rate parity held. What would the one-year forward rate be?

Solution. Interest rate parity holds when the dollar return on investing dollars equals the dollar return on investing SKr, or 1.07 = (1/0.1480) X 1.105 X f1, where f1 is the equilibrium one-year forward rate. The solution to this equation is f1 = $0.1433/SKr. Because the actual one-year forward rate exceeds this number, interest rate parity does not hold and a forward hedge is more expensive than a money market hedge.

Risk Shifting

To return to our previous example, General Electric can avoid its transaction exposure altogether if Lufthansa allows it to price the sale of turbine blades in dollars. Dollar invoicing, however, does not eliminate currency risk; it simply shifts that risk from GE to Lufthansa, which now has dollar exposure. Lufthansa may or may not be better able, or more willing, to bear it. Despite the fact that this form of risk shifting is a zero-sum game, it is common in international business. Firms typically attempt to invoice exports in strong currencies and imports in weak currencies.

Is it possible to gain from risk shifting? Not if one is dealing with informed customers or suppliers. To see why, consider the GE-Lufthansa deal. If Lufthansa is willing to be invoiced in dollars for the turbine blades, that must be because Lufthansa calculates that its euro equivalent cost will be no higher than the €10 million price it was originally prepared to pay. Since Lufthansa does not have to pay for the turbine blades until December 31, its cost will be based on the spot price of the dollars as of that date. By buying dollars forward at the one-year forward rate of $1.479/€, Lufthansa can convert a dollar price of P into a euro cost of P/1.479. Thus, the maximum dollar price PM that Lufthansa should be willing to pay for the turbine blades is the solution to

or

Considering that GE can guarantee itself $14.79 million by pricing in euros and selling the resulting €10 million forward, it will not accept a lower dollar price. The bottom line is that both Lufthansa and General Electric will be indifferent between a U.S. dollar price and a euro price only if the two prices are equal at the forward exchange rate. Therefore, because the euro price arrived at through arm’s-length negotiations is €10 million, the dollar price that is equally acceptable to Lufthansa and GE can only be $14.79 million. Otherwise, one or both of the parties involved in the negotiations has ignored the possibility of currency changes. Such naiveté is unlikely to exist for long in the highly competitive world of international business.

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