Forward exchange rates

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4 develop on three-month forward sterling. Both developments would be reducing the profitability of Z's strategy. This process would continue until the rates of return on the strategies chosen by X and Z came into equality (with some small allowance, as above, for transactions costs and any perceived difference in default risk). We would then have established covered interest parity. Covered interest parity when the gains from investing in a country with a higher interest rate are equal to the forward discount on that country's currency What would the final outcome be? Euro interest rates started below interest rates but Euro interest rates rose while interest rates fell. Thus, the interest rate differential between the two countries would have been reduced. The spot exchange rate of rose but the 3-month forward rate fell, establishing a discount on three month forward sterling. This establishes a general rule: The currency of the country in which interest rates are higher, will be trading at a forward discount; the currency of the country with the lower interest rates will be at a forward premium. Exercise 8.3 requires you to think about the relationship between spot and forward rates of exchange.

5 Exercise 8.3 At close of trading on the 4 th June 1999, the exchange rates for Japanese yen against the US dollar were: Spot \$1 = ; one-month forward \$1 = ; three months forward \$1 = (a) Was the yen at a forward premium or discount against the dollar? (b) What were the annual percentage premiums or discounts for yen one-month and three-months forward? (c) Given that US dollar one-month interest rates were 4.91 percent, approximately what must have yen one-month interest rates have been? In a simple example, an exporting company needs only to estimate when it will receive the dollars it is expecting and then sell dollars that period of time forward. An importing company, expecting to meet a bill in US dollars at some known time in the future, needs to buy dollars forward to the required amount. In practice, the selling bank in a forward contract may require the buyer to hold 'compensating balances' in the bank until the actual exchange of currency takes place, allowing the bank to use the funds until that time. Nonetheless, the forward contract gives the buyer certainty regarding the rate at which he will be able to acquire foreign exchange. There are, however, obvious limitations of the forward exchange rate market. To begin with, forward exchange rate deals are for specified periods (as we mentioned earlier, normally for one month or three months). In practice, however, the period involved may not be a round number of months. Again, it may be for a period rather longer than is usually arranged on the forward market. Worse, the date on which the payment will be made or is required may be uncertain and may change. Flexibility can be increased in a variety of ways, often through the use of derivatives contracts. For example, uncertain payment dates may be covered by taking out a forward option in which the maturity date is left open, although it must fall within a stated option period. Alternatively, swap deals may be entered into. Such deals may be either forward/forward swaps or spot/forward swaps. A forward/forward swap combines two forward contracts entered into at the same time but for different maturities. One contract is for a forward purchase, the other for a forward sale of a currency. For example, a UK exporter may have a contract for the sale of goods to a German importer with an invoice value of DM 2m and a contract date of 26/2/00, but the settlement date may be uncertain. On the contract date, the UK company takes out a forward contract for some arbitrary period (say, three months) i.e. it sells DM2m three months forward (maturing 26/5/00). Suppose, however, that on the 6/5/00, the companies agree that payment will take place not on 26th May but on 26th June. The UK firm must now: (a) counter the original forward contract and replace it with a contract for settlement on 26th June. So it now buys DM2m 20 days forward (maturing on 26th May), countering the first contract and

6 simultaneously sells DM2m forward 51 days, extending the delivery date to 26/6/00. A spot/forward swap is similar except that it combines a spot contract with a forward contract. This time the firm waits until the original maturity date (26th May) and: (a) buys DM2m spot; and (b) sells DM 2m forward 31 days. Yet another possibility is for the bank with which a client has taken out a normal fixed term forward contract to agree, for a consideration, to roll the existing contract forward. Foreign exchange swaps are used to a considerable extent in interbank business. Thus, if a UK bank needs Italian lire now, it may arrange with another bank to buy lire with sterling today and enter into a forward deal to sell the same quantity of lire back for sterling in, say, three months time. Assume the bank was willing to sell at 1 = lire, agreeing to buy back in three months at 1 = (lire are at a discount of 9 lire). The difference represents the swap rate and can be quoted as an annual rate either as a percentage (1.499% p.a.) or as basis points (149 basis points - 1 basis point is equal to.01%). Central banks have in the past frequently engaged in foreign exchange swaps (or have set up swaplines), especially between 1945 and 1973, in order to defend fixed exchange rates. Several other instruments have been developed to help to meet the needs of companies unwilling to face potential exchange rate losses, notably futures, currency options and currency swaps.

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