1. Explain how the Sports Exports Company could utilize the spot market to facilitate the exchange of currencies. Be specific. ANSWER: The Sports Exports Company would have an account with a commercial bank. As it receives payment in pounds each month, it would deposit the check at a bank that provides foreign exchange services. Each month, the bank would cash the check, and then convert the British pounds received into dollars for the Sports Exports Company at the prevailing spot rate.
2. Explain how the Sports Exports Company is exposed to exchange rate risk and how it could use the forward market to hedge this risk. ANSWER: The Sports Exports Company is exposed to exchange rate risk, because the value of the British pound will change over time. If the pound depreciates over time, the payment in pounds will convert to fewer dollars. The Sports Exports Company could engage in a forward contract in which it would sell pounds forward in exchange for dollars. For example, if it anticipated receiving a payment in pounds 30 days from now, it could negotiate a forward contract in which it would sell pounds in exchange for dollars at a specific forward rate. This would lock in the forward rate at which the pounds would be converted into dollars in 30 days, thereby removing any concern that the pound could depreciate against the dollar over that 30-day period. This hedges exchange rate risk over the short run, but does not effectively hedge against exchange rate risk over the long run.