You work for a global auto-parts company. Describe how you would use the spot and forward markets to manage the potential exchange rate risk between the countries from which you import (buy) components and the countries in which you sell auto parts.

An analysis is to be made on 3 different currencies in order to strategize with either using spot price or negotiating a forward contract. Please look at the hypothetical scenario below, to see if it clears up the exercise:

If we were to trade in Israeli New Shekel (ILS), an analysis of the spot/forward options should look somewhat like this:

First, if the purchasing company is based in the US, it should be determined or identified whether negotiations take place in USD or in Israeli Shekel.

If negotiations are in USD, then further analysis of spot and/or forward would not be too relevant, so let's assume that the negotiations will be in Israeli Shekel.

According to Oanda.com, the "spot price" for 1 ILS is .25 USD (rounded value of 25 cents.). This means that if I want to buy a part that is worth 100 ILS, then I would need 25 USD.

The spot price is the current price of the currency.

The forward rate is adjusted for inflation, and negotiated with the financial institution.

So let's say that I buy 1,000 units of this part every month, and I am afraid that if the ILS spot fluctuates too much from month to month, I might lose money on a future transaction. At this point, I investigate the volatility of the ILS:

After conducting a search on the Historical Exchange Rate for the ILS for the last year I found that the Period High was .26 USD for 1 ILS, the Period Low .25 USD for 1 ILS, meaning that for the last year the exchange between the ILS and USD has been pretty stable.

Let's keep in mind that if I bought the 1,000 units at 100 ILS each, then I would need roughly 250 USD for making the purchase at spot price.

Using the HSBC online forward calculator, I find that in 1 year my forward rate will be 0.2552 USD, and in 6 months 0.2535 USD, meaning that if I know that I will need to pay for those 1,000 units in ILS in the future, I can lock a price for the currency according to the forward rates, by negotiating a forward contract.

So with this information and what we know of the volatility of the ILS, should we lock in a forward rate, or can we continue using the spot price???

What would you do if the volatility and/or fluctuation was a lot higher and not locking in a forward rate could mean having to pay twice as many USD for the same part in 6 months or increasing the risk significantly? What would you do then?

So the strategy for each of the 3 currencies should be based on a similar analysis, using actual spot, historical, and forward rates.

Select any three currencies to use in your discussion.

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