Forward markets for foreign currency

Question 1

What are the two ways to quote forward contracts?

Answer 1

Quote the actual rate Ft,T . Also called outright rate.

Quote the swap rate Ft,T-St.

Question 2

What is a swap contract?

Answer 2

The combined spot and forward transaction (with opposite directions) is a swap contract

1. Purchase of FC spot against sale of FC forward.

2 Sale of FC spot against purchase of FC forward.

3 Purchase of FC short-term forward against sale of FC long-term forward.

4 Sale of FC short-term forward against purchase of FC long-term forward.

Question 3

What is the swap rate of a swap contract?

Answer 3

Ft,T-St

Question 4

What is to be said about this table?

Answer 4

1. In the above table, the USD/AUD forward rates are below the spot rate at all maturities. This means the AUD is trading at a forward discount.
2. Conversely, all AUD/USD forward rates exceed the spot rate, so the USD is trading at a forward premium.
3. There is a direct link between the swap rate and the money market interest rates of the two currencies.
   
   1. The reason is simple: Forwards stipulate an exchange of monies in the future. Hence, we have to take the time value of money into account. (Ergo, there is - expected to be - a higher interest rate in Australia, and so the AUD needs to be traded at a forward discount)

Question 5

What is the name of the four markets in the SFMM diagram?

Answer 5

Spot market

Forward Market

FC money market

HC money market

Question 6

Do the first diagram in the SFMM diagram

Answer 6

Question 7

Do the second diagram in the SFMM diagram

And what does it show?

Answer 7

Exchange rates spot and forward between the home and foreign markets

Question 8

Do the third diagram in the SFMM diagram…

What does it show?

Answer 8

Investments and loans in the home and foreign money markets

Question 9

What does the SFMM diagram show?

Answer 9

The SFMM diagram shows how we can synthesize any position - HCt , HCT , FCt , FCT by moving from node to node until we arrive at the desired position.

Question 10

What is the law of one price and what is the formulae?

Answer 10

The law of one price is the same as CIP (Covered Interest Rate Parity).

in the SFMM diagram: If CIP holds, shopping around (trying different routes along the SFMM diagram to arrive at a certain end node) is a waste of time.

Question 11

When including bid-ask spreads in the SFMM diagram, why is the spread in the forward market wider than in the spot market?

Answer 11

Note that bid-ask spreads for forward rates are wider than for spot rates (due to lower liquidity in forward markets)

Question 12

What is the first consideration you need to do when calculating the market value of an outstanding forward contract?

Answer 12

Whether it is a forward purchase or forward sale

Question 13

How do you calculate the HC market value of a forward purchase?

Answer 13

Question 14

How do you calculate the HC market value of a forward sale?

Answer 14

Question 15

What kind of exposure can be hedged by forward contracts?

Answer 15

Forwards are ideal for hedging contractual exposure.

Question 16

How do you calculate the contractual exposure?

What does it show?

Answer 16

1) A number B which tells us by what multiple the HC value V of a cash flow or asset changes when the exchange rate changes by /_\ S.
2) This tells you how sensitive the HC amount is to changes in the exchange rate.

Question 17

How do you hedge an A/R? And thereby eliminate the exposure completely?

How do you show this?

Answer 17

Intuitively, one can just sell the JPY 1m in the forward market to lock in the forward rate.

Question 18

Is the exposure positive or negative for A/R’s and A/P’s?
And how are these hedged?

Answer 18

• An A/R results in a positive exposure which is identical to the FC amount stated in the contract.
  
  • –> Can be hedged by a forward sale of FC (forward sales generate a negative exposure).
• An A/P results in a negative exposure which is identical in size to the FC amount stated in the contract.
  
  • –> Can be hedged by a forward purchase of FC (forward purchases generate a positive exposure).