Spot the day

[Fedex16]

I have a question which is getting a few people flummoxed, including myself!:

"A UK company purchases chemicals from a US distributor and is required to pay for deliveries in US dollars. The company is risk neutral and expects the exchange rate prevailing on the future payment date to be such as to make it indifferent between taking out a forward contract for the payment date, or being exposed to exchange rate variation. If the the payment date forward exchange rate contract rate is $1.50 and the forward rate contract transaction cost is $0.05 per $ to be provided, what is the expected spot rate on the payment day?"

Your thoughts would be appreciated

Best wishes

 

[Fedex16]

Long awaiited............

The company is risk neutral therefore the costs must be the same under the two options ie taking out a forward contract or exposing oneself to exchange risk.

The forward rate has been given as $1.50 to be applied on the payment date.

The spot rate today applied on the payment date at variation = forward rate less the risk implicit in that rate ie the forward Transaction costs

Hence the spot rate on payment day is $1.50 - ($1.50 * 0.05) = $1.425.