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International Finance

International Finance. Forward Rates Bill Reese. Learning Objectives. In this unit we will learn: Why people might trade forward exchange rate contracts How covered interest arbitrage determines forward rates What interest rate parity is. Spot vs. Forward Rates. Spot Rate

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International Finance

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  1. International Finance Forward Rates Bill Reese

  2. Learning Objectives • In this unit we will learn: • Why people might trade forward exchange rate contracts • How covered interest arbitrage determines forward rates • What interest rate parity is

  3. Spot vs. Forward Rates • Spot Rate • The price of a currency in terms of another currency for a trade today • Forward Rate • Price agreed upon today for a trade to be executed at a specified future date (30, 60, 90, 180 or 360 days)

  4. Forward Rates • Purpose: to lock in an exchange rate and thus eliminate XR risk • XR risk: the risk that the XR may move in an unfavorable direction • Risk averse investors may prefer certain forward rate to risky future spot rate

  5. Forward Rate Example • Purchasing manager for Best Buy • Places an order for 10,000 Sony televisions for Christmas • Must pay Sony in 6 months when delivered – pay in Yen • Agreed price is ¥300 million

  6. Forward Rate Example • Spot XR is .008 $/¥ • ¥300 million x .008 $/¥ = $2.4 million • Suppose yen appreciates to .010 $/¥ • ¥300 million x .010 $/¥ = $3 million • XR loss of $600,000

  7. Forward Rate Example • Note: $/¥ • When yen appreciates, XR increases • Yen is currency being priced • Currency in denominator • Yen buys more dollars • Takes more dollars to buy a yen

  8. Forward Rate Example • Suppose 180-day forward contract is available at .0085 $/¥ • Agree to sell dollars (buy yen) in 180 days at 117.65 ¥/$ (1/.0085 = 117.65)

  9. Forward Rate Example • Buy ¥ 300 million at .0085 $/¥ for $2,550,000 • Locked-in price • No XR risk

  10. Forward Contracts • Like Girl Scout Cookies • Order taken for future delivery specifying: • Good • Quantity • Delivery date • Price

  11. Forward Contracts • Usually with banks • Individually tailored • No money exchanged at time of agreement • Counterparty risk

  12. Forward Contracts • Forward premium • Forward rate > spot rate • Forward discount • Forward rate < spot rate • Our example • Spot rate = .0080 $/¥ • Forward rate = .0085 $/¥ • Forward premium

  13. Forward Contracts • Forward premiums and discounts • Indirect quotes Premium (discount) = SR – FR x 360 FR length = 125 – 117.65 x 360 = 12.5% 117.65 180 Negative value would be a discount

  14. Forward Rates • Forward rate ≠future spot rate (necessarily) • Determined by absence of arbitrage condition • Covered interest arbitrage

  15. Example • Spot rate = .73 $/CD • Six-month forward rate = .73 $/CD • U.S. interest rate = 5.0% • Canadian interest rate = 5.5%

  16. Today • Borrow $100 at 5% in U.S. • Convert to CD at spot rate: $100 ÷.73 $/CD = CD 136.99 • Invest CD in Canada at 5.5% for six months • Enter into 6-month forward contract to sell CD at .73 $/CD

  17. Six Months from Now • Investment grows to CD 140.76 • 136.99(1+.055/2) = 140.76 • Convert CD to $ with forward contract • CD 140.76 x .73 $/CD = $102.75 • Pay off debt • $100 (1+.05/2) = $102.50

  18. Covered Interest Arbitrage • Started with nothing • Ended up with something • Paid off debt of $102.50 with $102.75 from forward contract – leaving $0.25 • Riskless profit • Cannot last in competitive markets

  19. Covered Interest Arbitrage • Investors will notice • Everyone buys CD in spot mkt • CD appreciates • Everyone sells CD in forw mkt • CD sells at forward discount • Rates adjust until arbitrage opportunity disapears

  20. Interest Rate Parity • Prevents covered interest rate arbitrage • Country with higher interest rate • Currency sells forward at a discount

  21. Interest Rate Parity (1 + i) = Forward Rate (1 + i*) Spot Rate Where i = domestic int. rate and i*= foreign int. rate

  22. Interest Rate Parity (1 + .05/2) = Forward Rate (1 + .055/2) .73 $/CD Solving for forward rate: .728224 $/CD Gives you just enough to pay off the loan ($102.50)

  23. Interest Rate Parity • Country with higher interest rates • Currency sells forward at discount • Eliminates possibility for covered interest arbitrage • Transactions costs and taxes leaves range for forward rate

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