Consider the foreign exchange market between the British pound (GBP) and the U.S
ID: 1225524 • Letter: C
Question
Consider the foreign exchange market between the British pound (GBP) and the U.S. dollar (USD), as shown in the graph below. The exchange rate, measured in U.S. dollars per British pound, is shown on the vertical axis while the quantity of pounds is shown on the horizontal axis. Assume that you want to buy stock in a British hotel called Fawlty Towers and that you want to use $10,000 of your savings to do so. The current price per share of Fawlty Towers stock is 50 British pounds.
a. At the current exchange rate, what is the total value of your Fawlty Towers stock in British pound (GBP)?
GBP
b. If the exchange rate remains constant and your shares increase in value by 5%, what is the pound value and the dollar value of your financial investment?
___________ GBP
_____________ USD
c. Suppose that the foreign exchange market for the British pound (GBP) changes according to the graph below. At the new exchange rate, and if your shares still increase in value by 5%, what is the dollar value of your financial investment?
________ USD
d. Now suppose that the foreign exchange market for the British pound (GBP) instead changes according to the graph below. At the new exchange rate, and if your shares still increase in value by 5%, what is the dollar value of your financial investment?
_______ USD
Explanation / Answer
a) Price of a share of Fawlty Towers is 50 GBP. I have $10000 savings. At an exchange rate of $1.6/GBP, I have total savings of 10000/1.6 GBP which is equal to 6250 GBP. Hence, I have 125 shares of Fawlty Towers worth 6250 GBP.
b) If share value increases by 5%, both dollar value and pound value of portfolio increases by 5%. The dollar value of portfolio becomes $10500 while the pound value of portfolio becomes 6562.5 GBP.
c) The new exchange rate is $1.5/GBP. Hence the dollar value of the portfolio at this exchange rate is 6562.5 x 1.5 which is equal to $9843.75.
d) The new exchange rate is $1.7/GBP. Hence the dollar value of the portfolio at this exchange rate is 6562.5 x 1.7 which is equal to $11156.25.