Lecture 3: Forward FX Market and Interest Rate Parity

Question 1

What is a forward FX contract?

Answer 1

An agreement entered into today, in which two parties agree to exchange specific amounts of currency (pre-agreed EX rate) on an agreed date in the future.

*the contract is a commitment/obligation - both parties_must_ deliver on the contract.

Question 2

What is a Spot FX transaction?

Answer 2

Purchase or sale of foreign exchange where a rate is agreed between two counterparties today for physical delivery in two business days.

Question 3

What is a forward FX transaction?

Answer 3

Purchase or sale of foreign exchange where a rate is agreed between two counterparties today for a physical delivery at a date that is greater than two business days time.

Question 4

What is a swap FX transaction?

Answer 4

The simultaneous purchase and sale (or sale and purchase) of a spot and forward FX transaction at rates agreed between two counterparties. Usually the amounts involved are the same for one of the currencies on the spot and the forward transaction.

Question 5

What is a noon-deliverable forward?

Answer 5

Non Deliverable Forwards (NDFs): An NDF is a cash settled, forward contract on a thinly traded or non-convertible foreign currency. The currencies are not physically delivered; instead the contract is settled by calculating the difference between the agreed upon exchange rate and the spot rate at the time of
settlement for an agreed upon notional amount of funds. One party in the agreement will make a payment to the other party on the basis of the profit or loss on the contract. NDFs are normally, but not exclusively, quoted and settled in US dollars.

Question 6

What is a forward margin?

What are the rules for calculating forward margin?

Answer 6

The difference between the forward and the spot rate.

1. If the first number of the forward margin is greater then the second number of the forward margin the we subtract the margin. (if bid>ask subtract)
2. If the first number of the forward margin is less than the seconnd number then we add the margin.

Question 7

What are the major purposes for forward contracts?

Answer 7

Hedging and speculating.

Question 8

Why are forwards used to hedge international finance deals/trades?

What is the process that is used?

Answer 8

Forward contracts are used to eliminate incertainty in the FX markets (i.e. eliminate the uncertainty of future EX rate changes).

*a forward contract protects against the difference between F_t and S_T

In order to hedge risk with an futures contract you woould need to:

1. Buy/Sell a FC futures contract at time t depending on the position that they need to take at maturity T.
2. At maturity T the FC will be sold/bought at the agreed forward rate, thus eliminating the risk of fluctuation in S_T

Question 9

Why are forwards used to speculate on the FX market?

What is the process that is used?

Answer 9

If you hold the belief that there is going to be a change in the exchange rates you are able to purchase a forward contract to reflect that depending on your position/belief.

As with everything the prinnciple is buy low, sell high:

1. At time t if you believe that that the future FC spot price is going to rise/fall in the future then you need to buy/sell a FC forward contract.
2. At maturity T the FC will be bought at the agreed forward rate.

Question 10

What is an unbiased predictor?

How are forward rates unbiased preditors of the future spot rate?

Answer 10

An unbiased predictor is one that on average, closely forecasts the variable under consideration. Unbiased forward rates (UFR).

In theory UFR holds true (picture) however in practice it is unlikely as spot rates are difficult to predict. Bias is usually driven by risk aversion (i.e. a risk premium).

Question 11

What determines the forward rate?

Answer 11

Forward rates are determined by relative interest rates between two currencies (interest rate parity).

• The forward rate provides for equal returns in both currencies in the currency pair.

Question 12

How do you calculate the interest rate parity?

i.e. the no arbitrage price.

Answer 12

All else equal, the forward rate is higher:

• The higher the FC interest rate
• The lower the HC interest rate
• The higher the spot rate S
• if r_h > r_f then F < S*
• but if r_h < r_f then F > S*
• *If interest rate parity fails then there is an arbitrage.*

Question 13

What are the complication with interest rate parity arbitrage?

Answer 13

Interest rate quotations

• Usually qouted in annual terms. Conversion to monthly rates dependent on the acknowledged days in a year (i.e. AUD=365 while USD=360).

Bid-ask spreads are ignored.