Chap005__The Market for Foreign Exchange.ppt

Forward Rate Quotations The forward market for FX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available. Forward Rate Quotations Consider the exchange rates shown to the right. For British pounds, the spot exchange rate is $1.9717 = ￡1.00 while the 180-day forward rate is $1.9593 = ￡1.00 What’s up with that? Country/currency in US$ per US$ UK pound 1.9717 .5072 1-mos forward 1.9700 .5076 3-most forward 1.9663 .5086 6-mos forward 1.9593 .5104 Clearly market participants expect that the pound will be worth less in dollars in six months. Forward Rate Quotations Consider the (dollar) holding period return of a dollar-based investor who buys ￡1 million at the spot exchange rate and sells them forward: $HPR = gain pain $1,959,300 – $1,971,700 $1,971,700 = –$12,400 $1,971,700 = $HPR = –0.00629 Annualized dollar HPR = –1.26% = –0.629% × 2 Forward Premium The interest rate differential implied by forward premium or discount. For example, suppose the € is appreciating from S($/€) = 1.55 to F180($/€) = 1.60. The 180-day forward premium is given by: = 0.0645, or 6.45% 1.60 – 1.55 1.55 ×2 = f180,€v$ F180($/€) – S($/€) S($/€) = × 360 180 Long and Short Forward Positions If you have agreed to sell anything (spot or forward), you are “short.” If you have agreed to buy anything (forward or spot), you are “long.” Sp, if you have agreed to sell an FX forward, you are short, and if you have agreed to buy an FX forward, you are long. Payoff Profiles profit loss Spot exchange in 6 months $/￡ Payoff from long position in ￡10,000 Country/currency in US$ per US$ UK pound 1.9717 .5072 1-mos forward 1.9700 .5076 3-most forward 1.9663 .5086 6-mos forward 1.9593 .5104 $1.9593/￡ $2.10/￡ $1,407 $1.90/￡ ?$593 Consider the payoffs at maturity to a long position in a six month forward contract on ￡10,000. Forward Cro