The spot exchange rates and the forward rate for

a year delivery from now between the South African rand (ZAR) and the Mali West
African franc (CFA) are .023 and .025 ZAR per CFA respectively. How would we
speculate in the spot markets and in the forward one to make profit? Presuppose, we have
the equivalent of 10 million rand.

Answer:

Step-by-step explanation:

The forward rate between two currencies is 0.225 rand per CFA. The spot rate expected after one year is 0.025 rand per CFA. This shows that CFA is far more valuable against rand in the forward market as compared to spot market expected after one year. Therefore, in order to make a profit by a speculative transaction, we need to follow the below steps:

• Enter into a forward contract to sell CFA after one year at the price of 0.225 rand per CFA

• After one year, use the 10 million rand in initial capital to buy CFA in the spot market at the price of 0.025 rand per CFA

• Use the CFA bought in spot market to meet the obligations to sell CFA under the forward contract at the price of 0.225 rand per CFA

• The difference between the price paid for CFA in spot market after one year and price received in the forward contract is the expected profit.

The calculations are as under:

Amount of CFA to be bought in spot market after one year = Initial capital/Spot rate after one year

= 10 million rand/0.025

= 400 million CFA

Rand received by selling CFA under forward contract = CFA bought in the spot market × price under forward contract

= 400 million × 0.225

= 90 million rand

Profit on the transaction = Rand received by selling CFA under forward contract - Initial rand capital investment

= 90 million -10 million 

= 80 million rand