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Figures for Chapter 15 THE FOREIGN EXCHANGE MARKET (Investments : Spot and Derivatives Markets)

Figures for Chapter 15 THE FOREIGN EXCHANGE MARKET (Investments : Spot and Derivatives Markets) Figure 15.1 : Actual FX-forward contract :cash flows Quoted forward rate : F = 1.5($/£) Receive $150 t = 0 t = 1 Time Pay out £100 Will receive $150 and pay out £100 at t=1.

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Figures for Chapter 15 THE FOREIGN EXCHANGE MARKET (Investments : Spot and Derivatives Markets)

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  1. Figures for Chapter 15THE FOREIGN EXCHANGE MARKET(Investments : Spot and Derivatives Markets) © K. Cuthbertson and D. Nitzsche

  2. Figure 15.1 : Actual FX-forward contract :cash flows Quoted forward rate : F = 1.5($/£) Receive $150 t = 0 t = 1 Time Pay out £100 Will receive $150 and pay out £100 at t=1. No ‘own funds’ are used and no cash exchanges hands today (time t = 0) © K. Cuthbertson and D. Nitzsche

  3. Figure 15.2 : Synthetic FX-forward contract Using money market and the spot FX rate. Data : r(UK) = 11%, r(US) = 10%, S = 1.513636($/$) Create cash flows equivalent to actual forward contract begin by ‘creating’ the cash outflow of £100 at t = 1. (4) Receive $150 (2) Borrow £90.09 at r(UK) = 11% t = 0 t = 1 Time (3) Lend £90.09 x S = $136.36 in the US at r(US) = 10% (1) Pay out £100 Note : S = 1.513636 ($/£) and no ‘own funds’ are used. © K. Cuthbertson and D. Nitzsche

  4. Figure 15.3a : Calculating bid rate for forward deal Step 1 : Bank H actual FX forward contract. Receive $1 Actual forward contract (bid) t = 0 t = 1 Time Pay out euros How much ? Bank H will receive $1 and pay out euros at t = 1 What rate should Bank H charge for buying the base currency, USD forward - that is its BID RATE. © K. Cuthbertson and D. Nitzsche

  5. Figure 15.3b : Calculating bid rate for forward deal Step 2 : Hedging the forward position using spot FX and money markets. Create cash flows OPPOSITE to those in the F.C. Begin by ‘creating’ the cash outflow of $1. (4) Receive euros = S(1+rEU,b)/(1+rUS,O) (2) Borrow USD = $1/(1+rUS,O) t = 0 t = 1 Time (3) Sell these USDs for euros at spot rate (euro per USD). Hence at t = 0 lend EUROs = S/(1+rUS,O) at the bid rate rEU,b (1) $1 © K. Cuthbertson and D. Nitzsche

  6. Figure 15.4a : Calculating offer rate for forward deal Step 1 : Bank H actual FX forward contract. Receive euros How much ? Actual forward contract (offer) t = 0 t = 1 Time Pay out $1 © K. Cuthbertson and D. Nitzsche

  7. Figure 15.4b : Calculating offer rate for forward deal Step 2 : Hedging the forward position using spot FX and money markets. Create cash flows OPPOSITE to those in the F.C. Begin by ‘creating’ the cash outflow of $1. (1) $1 (2) Borrow USD = $1/(1+rUS,O) t = 0 t = 1 Time (2) Lend $1/(1+rUS,b) (4) will pay out = S(1+rEU,O)/(1+rUS,b) = F(offer) = 1.00553 To lend USDs at t = 0 we have to first borrow euros and switch them into spot dollars © K. Cuthbertson and D. Nitzsche

  8. Figure 15.5 : Hedging a forward deal with an FX swap Bank H : Cash flows (F = 0.625 £/$, S = 0.65 £/$, F-S = -250, hence rUK < rUS) Receive $10m A. The Outright forward contract F = 0.625 (£/$) Pay out £6.5m B. Spot transaction (S = 0.65(£/$)) Buy £6.5m (receive) t = 0 Sell $10m (pay out) C. The FX swap (swap points = -250) Buy £6.25m (receive) Buy $10m (receive) Swap points = -250 t = 1 t = 0 Sell £6.5m (pay out) Sell $10m (pay out) © K. Cuthbertson and D. Nitzsche

  9. Figure 15.6 : Actual and PPP exchange rate Price ratio ($/£) - PPP exchange rate S($/£) Actual exchange rate ($/£) © K. Cuthbertson and D. Nitzsche

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