LOS 58.H: DESCRIBE THE CHARACTERISTIC OF CURRENCY FORWARD CONTRACTS;

Question 1

DESCRIBE THE CHARACTERISTIC OF CURRENCY

FORWARD CONTRACTS;

Answer 1

Exchange rate risk is hedged with forwards or futures on an exchange rate
between 2 currencies.
• F = SoE(r-rf)T , where the forward exchange rate, F, is not necessarily a risk
neutral price if interest rates are not deterministic (if markets are not
functioning or not very liquid). S represents the exchange rate in the spot
market. The terms T and r represent time in fractions of a year and the interest
rate (assumed to be the domestic riskfree rate) and rf is the foreign interest
rate, respectively.
• If the spot exchange rate is .95 and the riskfree rate is 2% per year and the
contract is three months, then the forward price, F = .95E(.02.25) = .95476

Question 2

Characteristics of Currency Forward Contracts

Answer 2

“Currency forwards are widely used by banks and corporations to manage foreign exchange risk”

A currency forward contract enables a company to lock in a rate at which it will sell some currency and buy another currency in time.