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Mba 2 Semester (Finance Major) Chapter 5: Forward Exchange (Levi)
Mba 2 Semester (Finance Major) Chapter 5: Forward Exchange (Levi)
Mba 2 Semester (Finance Major) Chapter 5: Forward Exchange (Levi)
Question- 01: Define spot exchange rate & forward exchange rate.
Answer:
Spot exchange rate: The one- or two-day delivery period for spot foreign currency is so
short that when comparing spot rates with forward exchange rates we can usefully think of
spot rates as exchange rates for undelayed transactions. Spot exchange rate (or FX spot) is
the current rate of exchange between two currencies. It is the rate at which the currencies
can be exchanged immediately. According to the definition, delivery is theoretically
immediate; however, conventions of currency markets allow for up to two days for
settlement of a transaction.
The price of one currency expressed in terms of another currency at a given moment in time.
You can even use Google to find spot exchange rates. Just punch in a search query in the
Google search bar using the three-letter codes for currencies and it will get you the
exchange rate and even the final value of your money in the intended foreign currency. For
example, if you want to know the exchange rate between USD (United States Dollar) and
GBP (Great Britain Pound) in terms of USD/GBP, you simply write '1 GBP in USD'. Today,
18 June 2012, at 23:10 UTC, it gave me a value of 1.57 USD/GBP. It means it takes 1.57 USD
to buy 1 GBP.
Forward exchange rate: forward exchange rates involve an arrangement to delay the
exchange of currencies until some future date. A useful working definition is:
The forward exchange rate is the rate that is contracted today for the exchange of currencies
at a specified date in the future.
Forward exchange contracts are drawn up between banks and their clients or between two
banks. The market does not have a central location but instead is similar to the spot
market, being a decentralized arrangement of banks and currency brokers linked by
telephone, SWIFT, and clearing organizations.
A Forward Premium or Forward Points Premium is the positive difference between the value
of a specific currency on the spot market and the exchange rate obtained through a forward
or a futures contract.
Forward premium is when the future exchange rate is predicted to be more than that of the
spot exchange rate. So if the notation of the Exchange Rate is given like Domestic/Foreign
and there is a forward premium, then it means that Domestic currency will depreciate.
A forward discount is a situation whereby the domestic current spot exchange rate is
traded at a higher level than the current domestic future spot rates. The analysis of the
expectations from the market depends mostly on discounts and premiums. Also, they
enable one to know the currencies that should appreciate and those that will depreciate in
the near future.
If we assume that speculators are risk-neutral – that is, speculators do not care about risk –
and if we ignore transaction costs in exchanging currencies, then forward exchange rates
equal the market’s expected future spot rates. That is, if we write the market’s expected
spot price of currency j in terms of currency i as S*n (i/j) where * refers to “expected” and n
refers to the number of years ahead, then
For example, the market in general expected the euro to be trading at $1.3600/€ in one
year’s time, and the forward rate for one year were only $1.3500/€, speculators would buy
the euro forward for $1.35/€, and expect to make $0.0100 (= $1.3600 – $1.3500) on each
euro when the euros are sold at their expected price of $1.3600 each. In the course of
buying the euro forward, speculators would drive up the forward price of the euro until it
was no longer lower than the expected future spot rate. That is, forward buying would
continue until the forward price of the euro was no longer below the expected spot rate.
This can be written as:
Where inequality (3.3) means that the forward price of the dollar cannot be below the
expected spot price for the date of forward maturity: it must be greater than or at most
equal to. Similarly, if the market expected the euro to be trading at $1.3600/€ in one year’s
time and the forward rate for one year were $1.3700/€, speculators would sell euros
Where inequality (3.4) means that the forward price of the euro cannot be above the
expected spot price for the date of forward maturity: it is either less than or equal to the
spot price. Inequalities (3.3) and (3.4) are consistent only if the equalities of both
relationships hold, that is
As Table 3.3 shows, if the realized future dollar value of the euro is $1.34/€ instead of the
originally expected $1.35/€, the unanticipated decline in the euro by $0.01/€ causes a
decline in the value of the contracted €1million by ($0.01/€) × €1million, or $10,000. (Note
the € signs cancel in the multiplication to give a dollar amount.) On the other hand, if the
eventually realized US dollar value of the euro is $1.36/€, the dollar value of the contracted
€1 million increases by ($0.01/€) × €1million, or $10,000. Similarly, at a realized spot rate
of $1.37/€ the value of the €1million to be received under the forward contract provides a
gain of $20,000 ($0.02/€ × €1million).
Figure: 3.1
These gains and losses, and the associated unexpected changes in the spot exchange rate,
are shown in Table 3.4. For example, selling €1 million for the contracted $1.35 million
when the realized exchange rate at maturity is $1.34/€ means having a gain of $10,000: the
forward contract provides $1.35 million for €1million at the contract rate, whereas
€1million would provide only $1.34 million if sold at the realized spot exchange rate.
However, if, for example, the realized spot rate became $1.36/€ the forward sale of
€1million at $1.35/€ means having a loss of $10,000: at $1.36/€ the €1 million is worth
$1.36 million versus the $1.35 million for which the euros were sold. When these and the
other values in Table 3.4 are plotted as they are in Figure 3.2 we obtain a downward-
Question- 05: Discuss the concept of outright forward exchange and swaps.
Answer:
Outright and swap transactions As Table 3.1 shows, the largest part of average daily
turnover on the foreign exchange market takes the form of swaps. The balance consists of
outright forward contracts. As the name suggests, an outright forward exchange contract
consists simply of an agreement to exchange currencies at an agreed price at a future date.
For example, an agreement to buy Canadian dollars in six months at Can$1.0511/$ is an
outright forward exchange contract.
A swap, on the other hand, has two components, usually a spot transaction plus a forward
transaction in the reverse direction, although a swap could involve two forward
transactions in opposite directions. For example, a swap-in Canadian consists of an
agreement to buy Canadian dollars spot, and also an agreement to sell Canadian dollars
forward. A swap-out Canadian consists of an agreement to sell Canadian dollars spot and to
buy Canadian dollars forward. An example of a swap involving two forward transactions
Question- 06: Explain the forward quotations from the view point of outright
forward and SWAP.
Answer:
Swap points and outright forwards Even though some forward contracts are outright, the
convention in the interbank market is to quote all forward rates in terms of the spot rate
and the number of swap points for the forward maturity in question. For example, the 180-
day forward Canadian rate would conventionally be quoted as:
The quote on the spot is the way spot transactions themselves are quoted, and is in
Canadian dollars per US dollar. The spot rate means that the bid on US dollars is
Can$1.0265 – the quoting bank is willing to pay Can$1.0265 per US dollar – and the ask on
US dollars is Can$1.0270 – the quoting bank will sell US dollars for Can$1.0270 per US
dollar. The swap points, 23–27 in this example, must be added to or subtracted from the
spot bid and ask rates. Whether there is a need to add or to subtract depends on whether
the two numbers in the swap points are ascending (the second being higher than the first)
or descending. Let us consider our example. When the swap points are ascending, as they
are in the example, the swap points are added to the spot rates so that the implied bid on
US dollars for six months ahead is
That is, the quotation “Spot 1.0265–70; six-month swap 23–27” means the quoting bank is
bidding Can$1.0288 on the US dollar for six months forward. In other words, the quoting
bank is willing to buy six-month forward US dollars – sell Canadian – at Can$1.0288 per US
dollar. This is the six-month outright forward rate. Similarly, the above quote, “Spot
1.0265–70; six-month swap 23–27” is an implied outright ask on US dollars for six months
of
For example, if a one-month forward contract is agreed on Tuesday, September 11, a day
for which spot value is September 13, the one-month forward value date would not be
Saturday, October 13, but rather the following business day, Monday, October 15.The
exception to this rule is that when the next business day means jumping to the following
month, the forward value date is moved to the preceding business day rather than the next
business day. In this way, a one-month forward always settles in the following month, a
two-month forward always settles two months later, and so on. It makes no difference
whether the terminology “one-month,” “two-months,” and so on is used, or whether the
terminology is “thirty days,”“sixty days,” and so on. The same rules for determining the
value dates for forward contracts apply whichever way we refer to even-dated contracts.