2 Flashcards
What is a rate of exchange
Price of one currency in terms of another
Expressed as units of underlying currency equal to one unit of base currency
What is a spot transaction
The immediate purchase or sale of a currency
What does USD/GBP = 1.50 mean
£1 = $1.50
What is the bid price/ ask price
The bid price is the rate at which the dealer is willing to buy a currency
The ask price is the rate at which a dealer is willing to sell a currency
What is a forward
A forward is an obligation to trade in an asset at a predetermined price at a predetermined time
For a forward when is the payment for an asset
At delivery
For Foreign exchange a forward contract is one with delivery after 2 days
What can the forward rate F of USD/GBP be compared to spot rate (HI/LO)
Same as the spot rate
Higher than spot rate (£ at premium)
Lower than spot rate (£ at discount)
How is the forward premium or discount of forward currency expressed
In annualised percentages
(F-S)/S x 360/N x 100
(S-F)/S x 360/N x 100
N is no of days
What are forward points
Forward points = 10000 x [Forward rate - Spot rate]
What is forward rate in terms of forward points
Forward rate = Spot rate + (Forward points)/10000
What 2 options does a company have when companies have receipt or payment in foreign currency which are to be settled at a known point in the future? What does this have to do with hedging?
Option 1 - Wait until settlement date and fulfil transaction at the spot rate - risky as future currency rate unknown
Option 2 - Arrange forward contract - this hedges the foreign currency value
What is arbitrage
Simultaneous buying and selling of assets to take advantage of differing prices for the same assets
What is the formula for forward price
Forward price = [Spot price x (1+holding cost]/(1 + holding benefit)
What are examples of holding costs?
Cost of financing position
Storage cost
Insurance
Spoilage
Transportation
What are examples of holding benefits
Dividends
Coupon payments
Convenience yield
What is the future price for $/£ foreign exchange
F{$/£} = S{$/£}(1+i{$}N/360)/(1+i{£}*N/360)
Where i is interest rate
What formula can be obtained from future price for foreign exchange that is used for covered interest rate parity
(F{$/£}-S{$/£})/S{$/£}) =
[(i{$}-i{£})N/360]/(1+i{£}N/360)
From forward price formula
How does the covered interest rate parity simplify if i{£} is small? What implication does this have
If i{£} is small 1+i{£}*N/360 is approximately equal to 1
(F{$/£}-S{$/£})/S{$/£})*N/360 = (i{$}-i{£})
Forward premium/discount reflects interest rate differentials between 2 countries
What does the interest rate parity imply
Interest Rate Parity implies that currencies with high interest rates also have high depreciating currencies
What is the currency carry trade
A strategy where you borrow funds at a low interest rate in one currency (funding currency) and buy a higher yielding asset in another (target currency) in the spot market
The strategy is only profitable if interest rate differentials are not dominated by exchange rate movements
Shella Kinsey works for Barclays in London. Suppose she observes following data: Spot exchange rate: ¥/£=179.5, 30-day £ interest rate: 2.7% per year, 30-day ¥ interest rate: 0.6% per year, 30-day forward rate: ¥/£=180
She has about 1million pounds or the equivalent in yen for investment/arbitrage purposes. What should she do?
Uncovered interest rate arbitrage example
